Foreign exchange rates are both a market unto themselves and an influence on the fundamental situation of other markets. They reflect the strength or weakness of an economy and are a factor in it. This kind of duality can create a truly mind-spinning situation at times. There are a few things, however, which directly influence forex prices.
Interest Rates
Most people will think first of interest rates when the idea of evaluating one currency against another comes in to play. They are indeed a major part of the forex market equation. Interest rates on the one side determine the “yield” of a currency, while on the other side can be viewed as a barometer of the position of a country’s economy (or of an economic region like the European Union).
To that end, the same sorts of things which impact interest rates also play a part in forex prices. Inflation, or rather the expectations for inflation, is the single largest influence on interest rates. But even there it is not a clean scenario. If interest rates are rising because of strong economic growth leading to mild concerns about inflation, that tends to be a positive for a currency. On the other hand, if rates are rising because signs of inflation are starting to show (or significant inflation already exists), that can be a negative.
Keep in mind that the value of a currency is a reflection of its buying power. Inflation erodes that, so a country seeing high rates of inflation will generally have a weaker currency. This can easily be seen in the emerging markets where interest rates are often quite high, but the the currencies remain weak because of issues with inflation.
Trade
The forex market exists first and foremost to facilitate trade, and trade is a huge determinant in the value of a currency. The more a country’s goods are in demand, therefore requiring buyers to convert their currencies in to the exporter’s currency, the stronger it will be. It is a simple supply and demand equation. More demand means higher values.
Because of this influence, forex traders keep a keen eye on trade data. These figures, of course, are historical by the time the market sees them, meaning the trade transactions have already happened and their push or pull on a currency’s value have taken place. What traders want to know, however, is if money is flowing in to or out of a country.
Capital Flows
Capital flows are a parallel to trade. Rather than representing the value of goods and services being exchanged, they indicate the investment of capital in to a country. Investment works the same way as trade. A country receiving a lot of investment money is similar to a country selling a lot of goods on the trade market. It’s currency is in demand.
What creates capital inflows? Higher relative real interest rates (rates adjusted for inflation) is one thing. Opportunities for investment profits in a country’s stock market is another. Capital seeks returns. It will go where it thinks it is going to get the highest one for a given level of perceived risk.
Capital flows are seen in the balance of payments information released by the government. Traders look at it the same way they do the trade data. Is money coming in or going out of the economy?
Reserve Currency
You may have heard that the US Dollar is a reserve currency, which means other country’s keep a supply of Dollars on hand as a safety measure against adverse conditions. This helps provide demand for the Dollar, even when the items noted above would suggest a negative scenario.
A similar situation can be found in the fact that global commodities like oil and gold are denominated in US Dollars. Anyone buying them must exchange their own currency for Dollars in order to make a purchase, providing an added layer of demand for the US currency.
Comparison
The thing which makes the forex market so complex is the fact that when one is trying to perform the kind of fundamental analysis we have discussed here, it is a multisided equation. Looking at one country is not enough because a currency is valued and traded against an array of others, all of which have their own sets of considerations.
The comparison for a stock trader would be a spread trade in which one is going to buy one company’s shares and sell those of another related one in a bet that the former outperforms the latter. Obviously, you would buy the stock of the firm with the better fundamental outlook and sell the one which looks weaker.
This multiple analysis is enjoyable to some, but is probably the biggest factor behind the extreme popularity of technical analysis among forex traders.Â
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About the Author
John Forman, author of this blog, has traded for more than 20 years, is a professional market analyst, and authored The Essentials of Trading. He is an active participant in trading forums, consults for trading related businesses, as published literally dozens of trading articles, and has been quoted in a number of books and in the media.
** See John’s full bio.
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