Factors that influence exchange rates in the forex market

Several key factors can move the Forex market. All of these factors constitute what we call fundamental analysis. Understanding the impact of these key factors helps traders decide which positions to take in the markets for the chosen pair. Therefore, every trader should study these factors explained below as they will help them determine market trends.

Very often, the economic situation of a country is considered as the main factor that determines its exchange rate. However, economic factors cover a wide range of topics. Below, we will discuss nine significant aspects of a country’s financial condition that influence the value of its currency in the forex market.

Inflation

Generally, inflation is the rate resulting from the decline in the purchasing power of a given currency over a certain period of time. High levels of inflation mean that a particular currency is rapidly losing value. Under these conditions, the prices of goods and services tend to increase drastically. This situation occurs when too much of a country’s currency is in circulation, devaluing its exchange rate through excess supply. Of course, investors are primarily attracted to buying currencies that have lower inflation rates. Therefore, people tend to sell the currency of a country with a high inflation rate.

Degressive

‘Tapering’ is an absolute term encountered daily in forex trading. It is a strategy used by the Federal Reserve to reduce the amount of money in circulation. The term refers to the removal of quantitative easing measures adopted by the Federal Reserve and other central banks to stimulate their economies. Speaking of tapering, the government has slowed its purchases of assets, including mortgage securities and treasury bills. Tapering helps to slow inflation as the amount of money in circulation becomes limited. Tapering is a strategy used in a strong economy that needs help from the Central Bank. Of course, investors are attracted to buying a currency once the government has committed to the reduction because its supply will begin to diminish.

Employment rate

The employment rate is an economic factor that investors pay great attention to before buying or selling a particular currency. It is a means of measuring the average productivity of the country over a given period. Of course, when more people are employed, it suggests an improvement in productivity in the country. For this purpose, each country publishes its employment rate periodically, say monthly or quarterly.
Forex traders often pay close attention to the US NFP report released every first Friday of the month. NFP, which stands for Non-Farm Payrolls, is used to measure the total number of newly hired paid workers in the United States, excluding agricultural employees, private household employees, government employees and other organizations at non-profit. This report is used to measure the progress of the US economy by showing the increase or decrease in the rate of job creation by a country at the end of each month. As expected, increasing the employment rate by creating more jobs helps an economy. As a result, the monetary value of a country will appreciate in return. Otherwise, a high unemployment rate would reduce the value of the country’s currency.

Gross Domestic Product (GDP)

Gross Domestic Product data, produced annually with an interval of six months, is used to measure the total goods and services produced by the country during the said period. These data show the size of the country’s economy. A high GDP growth rate means that the country is highly productive and there is a growing demand for its products and services. An increase in a country’s production of goods and services generates a demand for the country’s currency in the foreign exchange markets.

Interest rate

Often, interest rates are seen as the extra reward investors get for holding a particular currency for an extended period of time. Investors tend to buy currencies that offer them high returns. High interest rates help strengthen the value of a currency and attract more investors. Similarly, high interest rates encourage saving and discourage borrowing. As a result, citizens do more productive work to earn money, which is a good sign for the economy.

Trade debts/deficits

Regular borrowing from other nations decreases the value of the country’s currency. Increased borrowing by a particular government suggests low productive activity being conducted in the country, which discourages investors and devalues ​​the country’s currency in the international market.

Trade balance

The trade balance measures the ratio of a country’s imports to exports. Countries with a high import rate have a weaker trade balance which devalues ​​their currency. On the other hand, countries with a higher export rate indicate a more productive labor force; therefore, their products are sold in other countries. This increases the overall demand for a country’s currency in the foreign exchange market.

Capital market/investment

The capital market measures the number of inflows or investments entering a country, essential data for stock and index traders. A rising capital market means that investors will buy more stocks and bonds, which is very good for the economy. Also, a healthy capital market shows that foreign investors now have confidence in the country’s economy, increasing the value of the country’s currency.

Monetary Policy

The monetary policy in place in a country often determines whether investors will enter or not. When severe economic policies impose many restrictions on investors, most foreign investors will withdraw or stay away. On the contrary, when the monetary policies of the government and the central bank are very favorable with many incentives for investors, more foreign investors will come to the country. Therefore, more capital will flow into the country’s market, thereby creating increased demand for the country’s currency across borders.

Political factors

How investors perceive the government in power goes a long way in determining their confidence in the country’s economy. When a perceived strong leader comes to power, many foreign investors tend to be attracted to the country. Often people define a country by its leaders. The personality of the manager and his understanding of the financial markets often determine his political decisions, the fields of activity he promotes and the incentives granted to investors. To this end, Forex traders pay close attention to various political news and events and predict their effects on a country’s economy. These often include changes in government spending and new regulations imposed on particular sectors or industries.

There is always significant change and volatility seen in the forex market during national elections in most countries. Often, the impact of the election on a country’s currency depends on who wins the election and how people perceive the new leader. In addition, the holding of a referendum or the division of a nation can have a considerable impact on the currency of the country. A case study could be made with the Brexit referendum held in 2016, which significantly affected the pound when the UK voted to leave the European Union.

War

Any war incident always misrepresents the economy and currency of the country simultaneously affected. Of course, war results in the destruction of physical assets and major investments, the loss of life and property, and the loss of jobs, among others. A good example is the ongoing Russian-Ukrainian war. As a result, the Russian ruble reached its lowest value. Likewise, the war has affected the EUR/USD and the European economy, which mainly depends on Russian oil and gas products for increased productivity. Often, commodities such as gold, silver, and crude oil appear to be the most in-demand assets during this period.

Viral risks (pandemic)

Sudden disease outbreaks within a country often lead to restricted travel and slow down economic activities. This means a decrease in production and an increase in consumption. A country’s economy could collapse if such restrictions last for long. A clear example of this is the current global pandemic known as the coronavirus. The United States and the United Kingdom have been the countries most affected by this pandemic. We have seen the UK generate its worst GDP growth rate in 2020 due to the limitations created by the global pandemic. Some economies have not yet fully recovered from the negative impact of the pandemic. Often, gold seems like the most viable asset to invest in during these volatile times.

Understanding all of these fundamental factors that affect the forex markets will make it easier for traders to succeed in the markets. Understanding and using the above factors in your trading distinguishes forex trading from gambling. Moreover, the above factors undoubtedly help traders decide what positions to take in the markets. Therefore, it is prudent for every trader to pay close attention to the influence that the factors discussed above are likely to exert on the market.

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