Table of Contents
Chapter 1: What is Forex Trading
Chapter 2: History of Money and Origins of Forex Trading
Chapter 3: Forex Trading Terminology
Chapter 4: Important Aspects of Forex Trading
Chapter 5: Players in The Forex Market
Chapter 6: Factors that Affect the Forex Market
Chapter 7: Risks Involved With Trading Forex
Chapter 8: Why Trade in the Forex Market
Chapter 9: How Forex Trading Works
Chapter 10: How to be a Successful Forex Trader
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Chapter 6: Factors that Affect the Forex Market
– Economy
– Government Policies
– Natural Factors
– International Trade
– Market Sentiment
– Political Factors
Chapter 6: Factors that Affect the Forex Market
Like most commodities, demand and supply forces in the market influence currency prices. These forces, in turn, are influenced by many factors which increase demand at times and supply at others, causing the currency values to fluctuate.
There are several factors which influence forex prices in this way. Anything that affects the flow of money in a country or between countries may impact currency values. Here are some of the key factors that affect the value of a currency:
The state of a country’s economy determines its currency value. A growing economy is generally the foundation for a stable currency that is valued highly in comparison with others. Any factors which impact the growth of the economy, either positively or negatively also affect currency prices. For example, during inflation, currency values typically fall. Inflation reduces the purchasing power of money so that less can be bought for each unit of money.
There are many economic indicators that need to be considered before making a forex trade decision. These indictors represent various aspects of the economy. As the general economic condition influences the currency value, these indicators are very useful in determining how the currency prices will fare given the current economic conditions.
- GDP – The Gross Domestic product of a country measures the industrial growth and production. This figure is a good indicator of how active the economy is. A steady GDP is the indication of a healthy, growing economy. Currency values are likely to rise when such circumstances prevail.
- Purchasing Power Parity – PPP measures the comparative power of a currency to purchase goods and services in a country. Consider two countries, A and B. 100 units of currency of A are equal to 1 unit of currency of B as per prevailing exchange rates in the market. PPP aims to measure the purchasing power of A’s currency with respect to B’s currency.
What can be bought for 100 units of local currency in country A should be available for 1 unit of local currency in country B. Then the countries are at par as far as purchasing power is concerned. If the countries are not evenly matched with respect to PPP and one currency has greater purchasing power than the other then it has a higher value in the forex market.
- Interest Rate Parity – The interest rates prevalent in both countries must also be comparable so that investments yield similar returns. The ability of a country’s currency to multiply in this way ultimately determines its own value. This is why interest rate parity is also an important factor in determining currency prices.
- Employment Levels – Employment levels determine the productivity of a nation. This is an indicator of future growth in the economy. A high level of employment means that most of the country’s population is engaged in contributing to economic growth. A good employment rate is a sign of a healthy economy and forms the basis for more investments.
This, in turn, increases the currency value. A low employment rate shows that fewer people are contributing to the economy. Production of goods and services is being carried out by a smaller proportion of the population, although consumption is at the same level. Currency value will be subdued when employment levels are low.
- Consumer Spending – The amount of money which the people of a country are spending gives an idea of what they think about the economy. If spending is low and saving is high, then it shows that people fear an economic downturn. This indicates that the currency value may fall in future.
Increased consumer spending shows that people are confident of their future earnings and investment yields. Consumer spending is also an indicator of the purchasing power of the average citizen and the standard of living. A prosperous economy is one where consumer spending is at a sustainable level. Such an economy is likely to have a stable currency with a high value.
The government constantly assesses the economy and takes actions. Government policies are created and implemented to encourage prevailing economic conditions during a positive trend and to correct the imbalance if the economy is not doing well.
Most economic policies fall under two categories – fiscal policies and monetary policies. Fiscal policies are those which outline the spending of the government. The annual budget is a part of the fiscal policy. It determines the areas where the government will be spending money. Government spending boosts the prospects of industries and segments of the economy.
Monetary policies are those which influence the various components of the country’s financial fabric to improve or sustain the economy. The central bank of a country implements the government’s policies by using various investment strategies in the markets.
Given the huge amount of funds the central bank can control, any action by the bank has a huge impact on the market. An inflationary trend can be curbed, falling prices can be shored and many other economic imbalances can be set right by central banks though their market activities.
Both monetary and fiscal policies affect currency prices, though the impact of monetary policies is almost immediate.
A natural disaster like floods, famine or drought in a country will have a negative impact on its currency value. The flow of money within the county’s boundaries is restricted severely under adverse circumstances like these.
The general public is more cautious in spending and there is likely to be a dramatic reduction in the overall amount of funds which are being used for investments. High risk investments like forex do not find many takers during these times. Government spending is also reduced because of huge expenditure in relief measures. Any excess funds are diverted toward rehabilitation programs because the government’s focus is on getting the country back on its feet.
Countries trade with each other to buy and sell products and services. As with any transaction, this too requires an exchange of money. In fact, the level of international trade is a good indicator of demand for a country’s currency. When countries with different currencies trade, the deal influences the value of currencies for both of them.
Such international trade is a permanent feature of any economy with goods and services being bought and sold from many different countries at any given point in time. When imports are higher than exports, the economy is said to have a trade deficit and when exports are higher than imports, there is a trade surplus. Governments publish the balance of trade figures showing this status every month.
A government has to pay for its purchases or imports and it receives money for its exports. In a trade deficit situation, it will be spending more of the domestic currency to buy foreign currency to fund the purchases. In this case, the domestic currency will fall in value in comparison with the foreign one. When exports exceed imports, there is a trade surplus which also translates into a higher domestic currency value. The status of this equation is given by the capital flow of a country.
Both capital flow and balance of trade are combined into the balance of payments statistics, which are released by the government. Three components make up the balance of payments of a country:
- Current account – Measures the goods bought and sold in international trade.
- Capital account – Measures the acquisition of disposal of assets that are non-financial in nature.
- Financial account – Measures the cross-border flow of money.
The balance of payments statistics play an important role in determining currency value of any country. This is one of the most important factors that a forex trader must consider when he makes investment decisions, especially long term ones.
Market sentiments play an important role in determining currency values. These directly influence demand and supply within the market. During times of global economic unrest, values will increase for stronger currencies which are linked to countries viewed as stable.
A country whose inflation levels are high will be viewed as a poor prospect for forex trading because future economic growth is likely to be hampered by high prices. Investors’ perception of an economy and interpretation of various economic indicators determine the overall market sentiment for a currency.
Politics often determines the direction which an economy will take. Political unrest brings a lot of uncertainty about the future and subdues both economic growth and currency value. An upcoming election or war may give rise to a cautious investment approach, reducing the capital flow into a country.
A change in leadership also often subdues the price movement of a currency in the forex market. Until the new leadership’s political views, monetary and fiscal policies and views on international trade become clear, the markets do not show a clear trend in the currency’s value.
A country that is considered politically unstable will not be a favored trading partner. This will affect its forex trade and the value of its currency in this market. On the other hand, a progressive political leader and a stable leadership pave the way for increased investments as investor confidence becomes strong.
Next Chapter: Risks Involved With Trading Forex