There is great volatility in the foreign exchange market. Foreign exchange rates can fluctuate in a matter of minutes or even seconds – some can move by as little as a fraction of one currency unit and some by drastic amounts of several currency units. These price movements are not random. Price action models suppose that currency values move in predictable patterns, while others point to fundamentals as major influences in foreign exchange rates.
In basic economics, the value of a currency is determined by supply and demand. When there is a greater demand versus supply for the currency, its value rises. Inversely, when the demand is low and the supply is high, the value drops. Various factors influence supply and demand for a particular currency. Forex traders should be aware of these factors that influence foreign exchange rates in order to understand how the market moves and to better predict opportunities for profitable trades.
Below are some of the market influences that affect foreign exchange rates:
Inflation. Generally, those with currencies that have lower inflation tend to remain strong against other currencies with upward inflationary push. As the purchasing power of a particular currency remains strong, its value over depreciating currencies logically increases. Lower inflation coupled with higher interest rates often result in more foreign investments and higher demand for the currency, therefore increasing foreign exchange rates.
Interest Rates. Along with inflationary forces, interest rates are associated with currency valuation. When interest rates are high, they offer greater return for investments. This makes it attractive for foreign investors to come in and enjoy greater yields on their money. A strong fiscal policy that keeps interest rates high and inflation down increases the value of an economy’s currency.
International Trade. The more revenues a country gets from its exports as compared to what it spends for its imports from its trading partner, the stronger its currency becomes. This is measured by the country’s balance of payments. When the country has a deficit in its balance of payments, it means that it owes more for its imports that it gained from its exports. A deficit drives currency values lower than the currencies of its trading partners.
Political events. Demand for a particular currency can rise or fall depending on the confidence of foreign investors on the country’s economic and political stability. Political strife or turmoil can cause loss of investor confidence and flight of foreign capital to other countries that are perceived to be more stable. This causes a loss of demand for the country’s currency and a drop in foreign exchange rates.
Market speculation. Much of the movements in the forex market are driven by market speculation. These speculations are often results of news and information that spur movement towards or away from particular currencies that are perceived to be stronger or weaker given certain triggers from market influencers. Price movements in the forex market are largely influenced by bigger traders as corporations, investment funds, and financial institutions. Market speculation on price movements are motivated by expectations of profits in the forex market.
