For a correct assessment of the situation in the Forex market, it is important to imagine what can affect exchange rates. For the international currency market, the currency is a commodity. The laws of supply and demand here are the same as in any other market. The main difference is that in the foreign exchange market there is no single means of payment, but exchange rates of currencies are formed relative to each other. To predict fluctuations in Forex rates and quotes, you should pay attention to the factors that determine supply and demand. Processes in the market may depend on many components. Moreover, the influence of each factor has a different meaning. Studying global factors will help to succeed in the trade.
The value of the currency of any country depends on the state of the economy, financial system, and even political structure. The difference in the development of processes in these areas forms the exchange rates. Here we will consider the main factors that have a long-term impact. A short-term effect on the movement of exchange rates can be exerted by a large number of trading participants – banks, Forex brokers, various funds.
- THE DIFFERENCE IN INFLATION RATES
The rate of inflation denotes the degree of depreciation of money during a certain time period. The currency of countries with low inflation is usually valued higher, and its rate is more stable. For example, in the United States, the inflation rate does not exceed 2% per year, and the US dollar has become the main currency in international settlements. There is no inflation in Japan, and even the reverse process is observed – deflation. Therefore, the Japanese yen (See the USD JPY chart ) is often bought up as a reliable currency “shelter”, which can protect money from depreciation. And vice versa, the currency of countries with high inflation often devalues and its rate is unstable. Inflation levels in different countries can vary very much, but this is only one of the factors influencing the exchange rate.
- INTEREST RATE DIFFERENTIAL
The interest rate level in the banking system of the state significantly affects the state of the entire economy and the financial sector. Inflation and the exchange rate directly depend on the interest rate. By manipulating the interest rate, the state through the central bank has an impact on the national currency and inflation. An increase in interest rates attracts foreign capital, which causes an increase in the exchange rate. For example, an increase in the discount rate of the US Federal Reserve increases the yield of government bonds. Japanese investors, buy more bonds, which requires American dollars, demand for them is increasing, and the dollar is growing against the yen. Interest rate cuts revitalize the economy, increase inflation and lower the exchange rate. So, after the crisis of 2008, the European Central Bank lowered the discount rate to zero, and the euro against the dollar fell from 1.5 to 1.04.
- TRADE DEFICIT
Any country buys a certain amount of goods abroad. Similarly, national goods are sold to other countries. In addition, there is a movement of funds in the form of payment for services, tourism income and the like. If a country, in general, spends more foreign currency than it receives, a trade deficit arises and fundamental analysis is included in the work. The demand for foreign currency is increasing and the exchange rate is increasing. To fill the deficit, it is necessary to borrow capital from foreign sources, which destabilizes the national currency and reduces its exchange rate. The surplus or balance of foreign trade ensures the stability of the exchange rate.
- STATE DEBT
Money intended for the functioning of the state is collected in the state budget. Most states do not have enough funds to finance all items of expenditure, or the money is received unevenly. In order to close the deficit and pay all bills on time, the state takes money in debt on domestic and foreign financial markets. This takes the form of issuing fixed-income bonds. These bonds are then traded in a free market where they can be traded above or below par. The value of bonds can affect exchange rates, reflecting the demand for bonds of a particular country. So, the growth of American Treasuries always causes a dollar appreciation.
Government debt does not always uniquely affect the economy and the exchange rate. Increasing the yield of government bonds attracts foreign capital and can help revive the economy. The worst option is when the state tries to reduce the budget deficit by issuing banknotes. The increase in volumes inevitably leads to inflation and depreciation of the national currency. There are cases of hyperinflation when money depreciated thousands and millions of times.
- DIFFERENCE IN THE VALUE OF IMPORTS AND EXPORTS
Changes in world prices for raw materials, energy, food products can also affect exchange rates. If a country exports oil and buys food, then with a decrease in oil prices its balance of payments will worsen, and the currency will become cheaper. If food also becomes cheaper, then the balance will not change. If the price of exports rises faster than imports, the balance will improve and the exchange rate will increase. There is even the concept of “commodity currencies”. This is, for example, the Canadian dollar, which depends on oil prices, or the Australian dollar, which fluctuates in accordance with the prices of metal ores and coal. Although the Russian ruble is not called a commodity currency, it significantly correlates with oil and gas prices.
- THE IMPACT OF POLITICAL STABILITY AND ECONOMIC EFFICIENCY
The political stability of the state attracts foreign investors and increases confidence in the country’s currency. Political upheavals, civil wars, popular unrest have a negative impact on the national currency, due to economic news of the Forex market and others. In a country with an unstable political situation, risks for foreign investors and international trade are increasing. And this causes an outflow of capital and a shortage of foreign currency. Political stability is closely linked to the economic efficiency of the state. If lawmakers establish laws that promote economic and financial development, the conditions for trade and investment will improve. And this ensures the stability of the national currency.