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“By keeping an eye on the key drivers, you can better anticipate currency movements and capitalise on opportunities.”
The forex market is one of the largest and most dynamic financial markets in the world. This is where fortunes are made (or lost) in the blink of an eye. In addition, currency exchange rates shape global trade and investment, affecting everything from the cost of your favourite imported goods to the returns on your stock investments.
But what affects exchange rates? In this article, we explore the top five factors that stir the forex pot by influencing the values of currencies.
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1. Interest Rates
Interest rates play a crucial role in determining a currency’s value. Countries with higher interest rates offer lenders a better return on their investment relative to other countries. This attracts foreign capital and causes the currency to appreciate. On the flip side, lower interest rates make a currency less attractive, leading to a decrease in demand and depreciation in the currency’s value.
Are you wondering what causes interest rates to go up and down? Central banks raise or lower them with the aim of controlling inflation, which is when the prices of the goods you buy go up over time.
For example, when inflation is too high, central banks raise interest rates to make borrowing more expensive and saving more attractive. This reduces spending and slows down the economy, keeping prices stable. As mentioned above, it also means higher returns on investment which causes an influx of foreign capital into the financial markets, increasing the currency’s value.
Conversely, when inflation is too low, central banks lower interest rates to make borrowing cheaper and saving less appealing. This encourages spending and boosts economic activity which keeps prices stable. At the same time, it causes the currency to depreciate due to lower returns on foreign investment.
2. Inflation
You have already had a sneak peek into how inflation affects the value of a currency through interest rate hikes and cuts. But there is more to inflation than that.
On the one hand, it can be the silent assassin of a currency’s value. This is because higher inflation rates lead to reduced purchasing power. For example, if a loaf of bread costs $1 today, it can cost $1.10 next year due to inflation. It means your money does not stretch as far because you need more of it to buy the same things.
As for lower inflation rates, they can cause an increase in the purchasing power of a currency relative to other currencies, which boosts its value.
On the other hand, the opposite can happen, especially when it comes to major currencies. This difference comes down to the way in which inflation impacts monetary policy and expectations around interest rates. For example, when inflation rises, the currency may appreciate on increasing expectations that the respective central bank will raise interest rates and bring inflation back down to its target.
The currency could appreciate even when inflation is below target but rising, and no rate hikes are needed. This is due to the expectation that there will be fewer rate cuts than previously expected.
A mirror image of this scenario is the case of falling inflation which adds to expectations of rate cuts, and thereby decreases the currency’s value.
3. Current Account Deficits
A current account deficit occurs when a country imports more goods, services, and capital than it exports. This imbalance means the country is spending more on foreign trade than it is earning, leading to a higher demand for foreign currencies and a net outflow of domestic currency to foreign markets. Think of it like a country living beyond its means.
If account deficits persist, they can undermine investor confidence. Investors may be spooked and they may seek opportunities in greener pastures. This further weakens the domestic currency, putting additional downward pressure on its exchange rate. Imagine it as a leaky boat; if it is not fixed, it simply keeps sinking lower.
4. Government Debt
Public debt is the elephant in the room when it comes to exchange rates in the forex market. It affects exchange rates by influencing investor confidence and economic stability. The reason for this is because large amounts of government debt can encourage inflation. Increased government spending, fuelled by debt, can cause a rise in demand, potentially outstripping supply and making prices go up.
In some extreme cases, governments resort to printing money to pay off debt. This increases the money supply and leads to even more inflation.
As with other factors, if investors smell trouble, they will move their money elsewhere, leading to capital outflow and further decreasing the currency’s value.
5. Terms of Trade
Terms of trade indicate the strength of a country’s exports versus its imports by measuring the ratio between export and import prices. When a country’s export prices rise faster than its import prices, its terms of trade improve. This indicates higher demand for the country’s exports, translating into higher demand for the country’s currency.
If terms of trade deteriorate, meaning import prices rise faster than export prices, the indication is that the demand for the country’s exports, and therefore its currency, is not as strong. This reduced economic confidence can lead to currency depreciation.
Final Thoughts
Foreign exchange rates are influenced by a complex interplay of economic factors, including interest rates, inflation, current account deficits, government debt, and terms of trade. To make informed decisions and navigate the forex market effectively, you need to have a good grasp of these factors. By keeping an eye on the key drivers, you can better anticipate currency movements and capitalise on opportunities.
How to Keep an Eye on These Factors
Staying updated on influential factors is easier than ever with our online Research Portal. Here, we regularly share news that can shake up the forex market, and help you anticipate important events with our economic calendar. You can also gain useful insights from the latest market commentary and forecasts written by our expert Research Team.
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