Every Monday through Friday, thousands of traders from every corner of the world trade forex, producing a daily trade volume exceeding $6 trillion and the world’s largest financial market. Compared to other financial markets, the forex market possesses the most depth and has experienced the most significant market growth, adding over 40% to its daily trading volume over the past decade.
Numerous factors determine exchange rates. Many of these factors are related to the trading relationship between the two countries. Note that exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries.
Unemployment Rates
The percentage of jobless people in a country’s working class is the unemployment rate. Countries calculate unemployment rates by measuring the volume of people who are willing and seeking work against those active in the nation’s workforce. Important exceptions to this category include those who are disabled, retired or in school.
Market volatility can stem from unemployment rates as it is a lagging indicator and reflects changes that have already taken place in a country’s economic state. The importance of unemployment rates in forex trading cannot be stressed enough, as unemployment rates reveal significant indicators of a country’s economic condition.
Here are three ways a forex trader may invest in unemployment rates:
- Lower Than Predicted – When a nation’s unemployment rate is lower than predicted, it is characterized by an increase in workers that generate income and consumption expenditure. Sometimes this prosperity is met with inflation, which then influences an increase in interest rates. Decreases in a nation’s unemployment rate are a positive force and indicate that the nation’s economy is strengthening, which creates a buying opportunity.
- Higher Than Predicted – When a nation’s unemployment rate is higher than predicted, it is met with decreased consumption, lower incomes and a dip in economic activity. As a result, the government may stimulate the economy by employing fiscal policies, creating demand within unemployment benefits, and hiring individuals for public work projects. When a nation faces rising unemployment rates, forex traders tend to look for selling opportunities.
- Lower Than Natural Rate of Employment – According to the Natural Rate of Unemployment, unemployment is not sustainable for long as it results in rising inflation. Should the United States unemployment rate fall beneath 5.5%, the Federal Reserve may raise federal fund rates to align economic growth.
When using unemployment rates to trade forex, it is most effective when compared on a year-to-year basis as less frequent comparisons may not accurately represent the actual unemployment trend.
Economic Growth and Output
The Gross Domestic Product (GDP), measurable on a monthly, quarterly, or annual basis, measures the output and production of produced goods concerning a nation’s economy. In short, it relays to economists and traders the overall health and growth potential of a country’s economy. In the United States, the GDP mostly concerns consumption, net exports, government spending, and investment.
Consumption includes costs like fuel, food, rent, and personal spending. Net exports are calculated by subtracting total imports from final exports, with a more productive economy reflecting a higher export value. Government spending includes government investments, governmental employee salaries along with social and defense program benefits. Lastly, investments concern actual business expenditures, including acquiring new equipment, manufacturing centers or household investment in property.
- A selloff of a domestic currency versus other currencies is likely to occur if the GDP is lower than anticipated.
- An appreciation and buy opportunity of the domestic currency versus other currencies is likely to occur if the GDP is higher than anticipated.
- Should the Gross Domestic Product of a nation reside within its projection, traders may need to compare the previous quarters and year to understand an underlying currency’s economic health better.
Interest Rates
Interest rates are the single most significant factor influencing the forex market, and they are managed by any of the eight global central banks. The eight major central banks include:
- US Federal Reserve Bank (US)
- European Central Bank (EUR)
- Reserve Bank of Australia (AUD)
- Reserve Bank of New Zealand (NZD)
- Swiss National Bank (CHF)
- Bank of Canada (CAD)
- Bank of England (GBP)
- Bank of Japan (JPY)
To fight off inflation, the central banks will raise rates. On the other hand, when a central bank decreases rates, they encourage lending and flood money into the economy. Traders who understand economic indicators such as the Consumer Price Index (CPI), Employment levels, Housing market, Subprime market and Consumer spending tend to better approximate how central banks will react.
More often than not, forex traders structure trading approaches when central banks make significant announcements regarding changes to monetary policy (monitor with an economic calendar) or by analyzing currency forecasts.
Not all interest rate changes are set in stone; sometimes, there are surprise changes to interest rates. When surprise interest rate changes occur, forex traders must be fast-acting to take advantage of market sentiment before the trend continuation resumes. Should a central bank hike up interest rates, it creates a buying opportunity and an appreciation in that nation’s currency. Should the central bank cut rates, traders tend to sell and buy currencies with higher interest rates.
Global Affairs
Political Impacts
A nation’s political election presents isolated cases where political uncertainty causes increased volatility to its currency and is primarily concerned with political changes about monetary or fiscal policy. To expand upon this, political parties or nominees who are identified as financially successful or appear to be more committed to driving economic growth tend to impact that nation’s currency more significantly in a positive manner. Other instances of this are when political affairs affect the forex markets which include corruption scandals and non-confidence votes.
Environmental Impacts
Natural disasters, including tornadoes, hurricanes, tsunamis, wildfires, earthquakes and flooding, are detrimental to a nation’s currency, infrastructure and morale. Destruction to infrastructure (a nation’s economic backbone ) from natural disasters severely debilitates economic output, consumer confidence and spending, and almost always negatively impacts that nation’s currency.
Impacts of Warfare
Warfare between nations can significantly impact associated countries’ currency and infrastructure while stifling economic conditions for years. Similar to natural disasters, there is a great deal of uncertainty surrounding future economic conditions and the health of nations involved in warfare.
For instance, the short-term economic availability of involved warring countries is greatly diminished, while post-war reparations stir as much uncertainty as war itself. Countries rebuilding from war are required to finance capital with lower interest rates, which, in turn, depreciates that nation’s currency value. Given the uncertainty surrounding warfare, nations involved in war tend to have more volatile currency movements than non-participating countries.
Balance of Trade
The balance of trade between nations can appreciate or depreciate its currency. For example, countries that possess a higher export demand experience an appreciation in their currency. Countries that rely more upon importing than exporting accrue trade deficits that drive down demand for the domestic currency (as they exchange their currency for other nation’s currency for foreign goods), therefore also depreciating.
Inflation Rates
Fluctuations to market inflation cause currency exchange rate changes. Countries with higher inflation experience currency depreciation, which is addressed shortly by the central banks raising interest rates to stimulate economic growth. When countries have a lower inflation rate, that nation’s currency tends to appreciate, creating a potential buy trade opportunity.
FX Influencers by Period
The economic strength and outlook of countries fuel the forex markets. To deepen the scope of your understanding of factors that influence the forex markets, here is a time frame reference:
Long-Term Determinants
- Purchasing Power
- Balance of Trade
- Gross Domestic Product
Warfare and environmental disasters have long-term effects that immediately influence the involved nation’s currency, injecting increased volatility and uncertainty into its market.
Closing Thoughts
Global economic factors are the driving force behind the foreign exchange market. Traders that understand the above influential factors and how they relate to the forex market with time are in the best position to maximize fluctuations in currency trading. Compared to other financial markets, the foreign exchange market is the fastest-growing, most liquidated and possesses a daily trade volume that is more than 25 times greater than all the world’s stock markets combined.
Additional Reading
9 Factors Affecting Forex Market Trading
Forex market trading is not difficult if you have a basic idea on when the foreign exchange of a country will change.
But how would you know that?
Over a period of time, it has been realised that the forex market can be affected by certain macroeconomic factors. In this article, I would take you through some factors that affect the forex market trading.
To read about the basics and essentials of Forex market trading, you can visit this article.
Let’s go through the list now. Here are the 9 Factors Affecting Forex Market Trading
1- The Political Landscape
An economy grows when the government willingly takes steps to improve the living standard of its populace. Thus, a stable government may be the first sign of an investor-friendly country. It means the economy has fewer roadblocks and higher chances to grow.
How it relates to forex market trading: A trader might buy the currency of a country whose political conditions are stable.
Example in the world of Foreign exchange trading:
News of Brexit led to a dive in the value of the GBP when compared to the US Dollar.1
2- Inflation Rate
No surprises there. If the country’s inflation rate is relatively lower in comparison to the other, its currency is expected to appreciate in value compared to a currency with the higher inflation rate.
How it relates to forex market trading: An investor would seek to buy a currency where the inflation rates are lower.
Example in the world of Foreign exchange trading:
As you can see in the graph, as the inflation rose in Zimbabwe, its currency value devalued aggressively.2 Thus, the Zimbabwean dollar is not an attractive destination for Forex traders.
3- Interest Rate
I’d like to begin explaining this with an example of a shopkeeper selling pens to five kids.
Let’s say you are the shopkeeper selling pens for INR 10. Now, five kids come to you with 10 rupee notes demanding a pen, but the problem here is that you only have three pens. One scenario is that you start a bidding war and the one who needs it the most will bid double or triple the price of the pen. But wait! There is another way.
Suppose you realise that two of those kids don’t really need the pen right now. So you tell them to deposit the 10 rupees with you and when you get new stock, you will give it to them. To sweeten the deal, you say that you will give them 1 rupee along with the pen. The two kids agree and your problem is solved.
Granted, this is an oversimplification, but this is the logic whenever the central bank decides that the inflation rate is growing out of control, it steps in to control it by increasing the interest rates and thus, rein in the amount of currency in the market.
An increase in interest rates is a good sign for investors as the currency rate increases due to the increased interest rate for the currency.
How it relates to forex market trading: An investor will gravitate towards the economy with higher interest rates as they increase their rate of return. This increases the demand for the currency and in turn, increasing the exchange rate.
Example in the world of Foreign exchange trading:
The RBI has increased the interest rate to stem the fall of the Rupee. 3
4- Government Debt
Would you give money to a person who is already in debt? You wouldn’t.
It’s the same concept here, higher the debt of a country, lower are the chances of it attracting foreign capital, which in turn lowers the country’s exchange rate.
How it relates to forex market trading: An investor may see the government debt trend over the years to determine if it is a sound decision to invest in the currency of the country
Example in the world of Foreign exchange trading:
One of the reasons for the weakening of the Indian rupee is the government debt which has not decreased due to the rise in oil prices.
5- Terms Of Trade (Export Prices To Import Prices Ratio)
Terms of Trade can be addressed as the ratio of Export Prices To Import Prices. If the country’s terms of trade are large, ie they have more exports than imports, the currency will always appreciate and there will be demand for it. This means its currency value will be greater than another country whose Terms of trade are lower in comparison.
How it relates to forex market trading: An investor may like to invest in a country whose exports are greater than their imports.
Example in the world of Foreign exchange trading:
As China’s terms of trade are mostly positive, it is an attractive source for forex trading.4
6- Speculation
This is not exactly a measurable factor. If there is speculation that the currency rate will increase, other investors will demand more of the currency and its currency rate increases further. The same holds true for the other side.
How it relates to forex market trading: The trick here is to identify a bandwagon effect and make sure you are out of it before the effect wears away.
Example in the world of Foreign exchange trading:
In 2005-06, with low lending rates in the housing market in the US, there was speculation that property prices would rise and this, in turn, would increase the value of the dollar.
7- The Capital Market
You can get a rough idea of how the economy is doing by seeing the trend of the capital markets. A lengthy dive of the stock market usually indicates low confidence from the investors and thus, can be useful for predicting the currency rate compared to the other country.
How it relates to forex market trading: If the capital markets show an uptrend, it means the currency rate will increase.
Example in the world of Foreign exchange trading:
Since 2005, as the capital market soared in China, the USD/CNY currency pair decreased, signifying that the yuan had strengthened.5 6
8- Employment Data
Every country releases employment rates periodically. This is another indication of how well the economy is doing. A high unemployment rate means the economy is not growing in line with the population of if the economy has stagnated.
How it relates to forex market trading: A high unemployment rate could lead to a depreciation in the currency value and thus decrease the forex rate of that currency.
Example in the world of Foreign exchange trading:
After the US non-farms payroll report was released in September with an upbeat tone, the US Dollar index (DXY) ie the performance of the US Dollar compared to a basket of foreign currencies increased from 94.95 to 95.35.7
9- Economic Planning
The monetary and fiscal policy of a country will give you a good idea if it is investor friendly or not. Thus, if the government has plans and incentives in place to attract foreign capital, investors may flock to this country and increase the demand for the particular currency.
How it relates to forex market trading: The country’s currency rate will increase due to significant investments from overseas.
Example in the world of Foreign exchange trading:
After the budget of 2018 was presented, in the domestic market, BSE and NSE saw a downward trend and it was estimated that collectively, 4.6 lakh crore was lost in Indian stocks.
When it comes to forex market trading, the rupee saw a 44 paise fall when compared to the US Dollar.
These are a few factors which every investor should know before starting foreign exchange trading.
After going through this article about various factors that affect forex trading, not only do you know the basics of Forex trading Strategy, but you have also understood how certain factors affect trading in the forex market.
But, why stop here? Let’s try to understand how to evaluate a country’s exchange rate compared to a basket of other countries. Hint: It’s called REER. Let’s head on over to that article right now.
More Reading … 6 Factors That Influence Exchange Rates
Aside from factors such as interest rates and inflation, the currency exchange rate is one of the most important determinants of a country’s relative level of economic health. Exchange rates play a vital role in a country’s level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most-watched, analyzed, and governmentally manipulated economic measures. But exchange rates matter on a smaller scale as well: they impact the real return of an investor’s portfolio. Here, we look at some of the major forces behind exchange rate movements.
Overview of Exchange Rates
Before we look at these forces, we should sketch out how exchange rate movements affect a nation’s trading relationships with other nations. A higher-valued currency makes a country’s imports less expensive and its exports more expensive in foreign markets. A lower-valued currency makes a country’s imports more expensive and its exports less expensive in foreign markets. A higher exchange rate can be expected to worsen a country’s balance of trade, while a lower exchange rate can be expected to improve it.
Key Takeaways
- Aside from factors such as interest rates and inflation, the currency exchange rate is one of the most important determinants of a country’s relative level of economic health.
- A higher-valued currency makes a country’s imports less expensive and its exports more expensive in foreign markets.
- Exchange rates are relative and are expressed as a comparison of the currencies of two countries.
6 Determinants of Exchange Rates
Numerous factors determine exchange rates. Many of these factors are related to the trading relationship between the two countries. Remember, exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries. Note that these factors are in no particular order; like many aspects of economics, the relative importance of these factors is subject to much debate.
1- Differentials in Inflation
Typically, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the 20th century, the countries with low inflation included Japan, Germany, and Switzerland, while the U.S. and Canada achieved low inflation only later.1 Those countries with higher inflation typically see depreciation in their currency about the currencies of their trading partners. This is also usually accompanied by higher interest rates.
2- Differentials in Interest Rates
Interest rates, inflation, and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates – that is, lower interest rates tend to decrease exchange rates.
3- Current Account Deficits
The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest, and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country’s exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.
4- Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.
In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country’s debt rating (as determined by Moody’s or Standard & Poor’s, for example) is a crucial determinant of its exchange rate.
5- Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country’s exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows’ greater demand for the country’s exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country’s currency (and an increase in the currency’s value). If the price of exports rises by a smaller rate than that of its imports, the currency’s value will decrease in relation to its trading partners.
6- Strong Economic Performance
Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.
The Bottom Line
The exchange rate of the currency in which a portfolio holds the bulk of its investments determines that portfolio’s real return. A declining exchange rate obviously decreases the purchasing power of income and capital gains derived from any returns. Moreover, the exchange rate influences other income factors such as interest rates, inflation and even capital gains from domestic securities. While exchange rates are determined by numerous complex factors that often leave even the most experienced economists flummoxed, investors should still have some understanding of how currency values and exchange rates play an important role in the rate of return on their investments.
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What Affects the Forex Markets?
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