Understanding the factors that influence currency exchange rates can help make you a better trader since it enables you to determine the direction in which the market may move, either bullish or bearish. Since exchange rates are a reflection of the state of a country’s economy, breaking economic developments can affect them, positively or negatively. Exchange rates also determine a country’s relationship with its trading partners. If its exchange rate appreciates, its exports are more expensive, since more units of a local currency are needed to pay for them, while imports become cheaper. Here are some of the factors that can affect currency exchange rates that you should look out for.
- Interest rates: These rates represent the cost of borrowing money, as they determine the amount of interest a borrower can be charged. Increasing benchmark interest rates are among the most important policy tools used by central banks to stimulate the domestic economy, since they affect the retail interest rates commercial banks charge their clients. How do interest rates affect exchange rates? When interest rates go up, there is an increased demand from investors for the local currency, causing the exchange rate to appreciate. Conversely, when interest rates go down, it may cause investors to leave the country and sell their local currency holdings, causing the exchange rate to depreciate.
- Employment outlook: The jobs situation is one of the most important factors that can affect the exchange rate since it determines the amount of consumer spending in the economy. High rates of unemployment mean that there is less consumer spending since people are cutting back due to uncertainty and thus, less economic growth. This can cause currency exchange rates to depreciate since there is less demand for the local currency. When the jobs market is weak, the central bank may also increase interest rates to boost growth, putting further pressure on the currency and causing it to weaken.
- Balance of trade: This indicator represents the difference between a country’s exports and its imports. When a country exports more than it imports, the balance of trade is positive, since more money is coming in rather than leaving the country and can cause the exchange rate to appreciate. On the other hand, if imports exceed exports, the balance of trade is negative, since merchants have to exchange more local currency to pay for these, which can result in currency exchange rates depreciating.
- Central Bank Policy Actions: A country’s central bank often intervenes in the markets in order to boost economic growth and promote job creation, which can put pressure on the local currency, causing it to depreciate. One example are the quantitative easing measures being used by the US Fed to reduce the unemployment rate, which involves buying mortgage-backed bonds while at the same time maintaining its benchmark zero exchange rate regime in order to encourage commercial banks to lower their rates and stimulate borrowing. Both of these actions are expected to weaken the US dollar, since their effect is to increase the money supply circulating in the economy, resulting in lower currency exchange rates.