What Affects Currency Fluctuations


Introduction

We've looked at what Forex is and how to read quotes, so now let's look at some of the factors that affect the price of currency. Numerous factors determine exchange rates and all affect currency pairs. The following are some of the main factors affecting currencies. 

Inflation

As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies.   Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. However, high inflation is usually accompanied by higher interest rates which can increase demand on a currency over a shorter timeframe - There's a balance to be made.

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.

However, the impact of higher interest rates is mitigated 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. Again, there's a balance affecting currency pairs.

Trade Deficit

A trade deficit (or current-account deficit) shows the country is spending more on foreign trade than it is earning. When we buy goods and services from foreign countries, we must pay in their local currency. This increases the demand of the foreign currency, whilst reduces the demand for ours. 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 depreciates our currency until domestic goods and services are cheap enough for foreigners and foreign assets are too expensive to generate sales for domestic interests.

Sovereign Debt

Nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation.  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 (bonds) for sale to foreigners, thereby lowering their prices. We'll talk about bonds in Oil, Gold and Bonds Correlation.

Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations (Think of Greece in 2011). 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 S&P for example) is a crucial determinant of its exchange rate.

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. This increases demand & revenue for the country's exports, which provides increased demand for the country's currency. 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.

Politics and General 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. 

To Sum Up

Hopefully you should have a better understanding of how currency values and exchange rates play an important role in the profitability of your trading day.  We now know what kind of things influence currency prices, but as you will have learned there's a complex collection of factors that push and pull on exchange rates.  One resource that can be used to determine shorter term moves is supplied by forexfactory.com.  Here they supply an up-to-date economic calender, highlighting up-an-coming economic releases and an explanation of each of them.  For more on this read Top News to Trade and Why? in Mod.8

Technical analysis is not an exact science and although these ideas can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course. <<<<<<< HEAD

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