Factors Affecting Exchange Rates in the Foreign Exchange Market

Several key factors can affect the forex market. Together, these factors form what we call fundamental analysis. Understanding the impact of these important factors helps traders decide which positions to take in the market for their chosen portfolio. Therefore, it is imperative for every trader to study these factors explained below as these factors will help them determine the market trend.

Inflation reports are critical economic indicators for FX trade. Essentially, differentials in inflation are directly tied to a country’s economic health, and the rate of inflation provides investors with an idea of what to expect in terms of volatility and viability.

Compared to their trading partners, countries with a high inflation rate typically face a depreciation in the value of their currency. Combined with higher interest rates, this reduces the purchasing power of said currencies over time.

Countries with a low rate of inflation tend to experience rising value in their purchasing power. This is due to the fact that stable economies with higher comparative inflation face a slower rate of appreciation, and unstable currencies tend to decrease in value.

You may have noticed that interest is directly tied to inflation. However, they are still regarded as elements that operate independently from each other. Interest rates are controlled by central banks, and they are used to counter the negative effects of inflation.

A higher interest rate means more profitability for lenders, which attracts foreign investors and gradually increases a currency’s value in relation to others. That being said, if the inflation rate is high as well, it can mitigate the potential impact of high interest.

Low and high interest rates can both be beneficial. Lower interest rates can spur economic growth, while high interest rates can stop economies from growing too fast. Ultimately, economies have to be balanced for global trade to function efficiently.

Balance of economy
The current account of any given country is a reflection of all goods, services, and dividends that have been traded with other countries. Deficits in this account represent more spending than earning when it comes to foreign trade.

To put it simply, a country in debt owes money to foreign sources of income. There are two causes for this debt; the first is that the country needs more foreign currency than it can afford, and the second is an excess supply of local currency.

Foreign assets become too expensive if a country can’t manage its debt, and the result is that businesses are unable to generate enough domestic sales. This stagnates the economy, reflecting the disparity between local production and foreign investment.

Terms of trade
Terms of trade is a ratio that compares import prices to export prices. It’s directly related to current accounts and the balance of payments, which includes both public and private sectors of a country’s economy.

If export prices rise at a greater rate than import prices, the terms of trade have improved for the country in question. Greater demand for exports creates an increase in currency value, moving the exchange rate in a positive direction.

If import prices are going up faster than export sales, a currency’s value decreases to account for that change. Terms of trade provides one of the earliest signs of a currency’s future performance, making it an incredibly important value indicator.

Political stability
When it comes to investment, foreign capital is more likely to favor economies with strong performance and long-term stability. Political turmoil can have lasting effects on performance and stability, and investors will exit a market that faces high instability.

The higher the political risk, the greater the chances of an economic downturn. A country facing a crisis in diplomacy is best left to its own devices, as that turmoil can have a resounding impact on other markets around the world.

Confidence in a currency can be built through stable infrastructure and effective policymaking. These are only possible with a capable and efficient government that can inspire foreign investors to speculate in favor of the local currency.

The constant fluctuations and high liquidity of forex make it an appealing avenue for speculative income. Speculation is integral to the growth of global trade, but it also has the potential to cause notable repercussions in certain situations.

It can cause increased volatility and even go as far as causing what many people refer to as ‘market manipulation.’ It puts a strain on countries with limited forex reserves, and larger orders can threaten a region’s economy in the worst-case scenario.

Gross Domestic Product (GDP)

Gross Domestic Product (GDP) data is produced annually at six-month intervals and measures the total amount of goods and services produced by the country during the said period. This figure shows 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 creates demand for that country’s currency in the foreign exchange market.

Virus harm

Sudden outbreaks of disease within a country often lead to restricted movement and a slowdown in economic activity. This means less production and more consumption. If such restrictions persist for too long, a country’s economy could collapse. An obvious example is the current global coronavirus pandemic. The United States and the United Kingdom are the countries most affected by the epidemic. Due to the restrictions of the global epidemic, we have seen the United Kingdom with the worst GDP growth rate in 2020. Some economies have not yet fully recovered from the epidemic.

Understanding all these fundamental factors that affect the foreign exchange market will make it easier for traders to succeed in the market. Understand and use the above factors in your trading to differentiate forex trading from gambling. Furthermore, the aforementioned factors undoubtedly help traders decide which positions to take in the market. Therefore, every trader should carefully pay attention to the possible impact of the above factors on the market.

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