The values of global currencies fluctuate constantly on the forex market. This is because they have been allowed to float freely on the open market, their price determined through the trading activities of brokers and investors. But, when a currency is not backed by an asset or commodity with an intrinsic value, how do traders establish what each is worth?
Our five fundamentals of forex will help you to understand the processes and influences that shape price discovery on the forex market.
Interest rate movements are among the most powerful influencers of forex valuations. A change in the interest rates of a major economy can effect currency prices immediately, and create a chain reaction of price movements across the foreign exchange market. But why are interest rates so important to forex traders?
Interest rates are set by central banks, and dictate the price of borrowing. When interest rates are high, it costs more to pay off an outstanding debt. At the same time, an account which is in credit will accrue higher interest payments when interest rates are high. Because of this, smart traders may choose to buy currency which enjoys higher interest payments, while selling currencies from countries charging low interest rates on its repayment.
A change in interest rates can therefore be incredibly influential to the forex markets; even the expectation of moving rates can result in a revaluation of multiple global currencies. This occurred in 2015 when the government of Singapore was forced to raise its interest rates after the US Federal Reserve had hinted at a change to its own rates. The rumour alone was enough to trigger a large sell-off of Singaporean dollars in favour of the US currency.
Economic stability is a measure of a nation’s overall financial health.
A stable economy represents a low-risk investment for traders, and demand for that currency may naturally increase. Meanwhile, a volatile economy can dissuade forex traders from making a long term or high value commitment; it may even encourage investors to speculate against the future prospects of the currency.
This can create a ripple effect: as confidence falls, investors exit the market and sell their holdings, causing currency values to fall on the open market – this will often exacerbate any underlying risk of instability or default.
Of the five fundamental factors that influence currency pricing, the role of international trade is potentially the most complex – because it is one of balance. International trade can affect the currency valuation on the open market but, equally, the price of a currency can affect a nation’s ability to sell goods to other countries. The relationship is therefore one of constant reaction and readjustment.
For example, when the cost of importing goods is lower than the value of exported products, a nation’s terms of trade are said to be improving. This is often interpreted as a sign of stability for investors, and forex traders may consider the currency to be an attractive prospect. Conversely, a country which spends vastly more than it sells in international trade may be viewed with caution, and attract fewer buyers in the forex market.
However, as traders purchase the currency of the successful exporter, demand for its money increases, and its value rises. The rising currency price makes it increasingly costly for foreign buyers to purchase goods from that nation, and its exports eventually begin to fall.
Why is this significant to a forex broker? Because if a currency is undervalued in relation to its terms of trade, it has the potential to offer long term profits. Conversely, when a currency is valued so high that it has already begun to negatively impact upon exports, it may be due for a downward readjustment in the near future.
Major political, social and economic events can play a direct part in establishing currency values on the open market. When a nation experiences prolonged periods of instability, the forex market views the prospects of its currency with uncertainty, and trading may be characterised by increased volatility, diminishing volumes, or falling prices.
World events that can be seen to influence the forex markets may be as commonplace as a democratic election, or as unpredictable as civil unrest or a natural disaster. When Great Britain voted to leave the European Union in June 2016, the price of the pound fell by 10 per cent against the US dollar in only a few hours.
Governments use public debt to fund infrastructure projects which can lead to growth and prosperity in the future. However, when public debt increases too rapidly, or grows too high, it may cause confidence among investors to fall.
Government debt is created through the issuance of securities and bonds. When a government issues securities, new money enters the economy – and this dilutes the value of existing currency holdings. A diluted currency will generally be expected to fall in value on the forex market. For example, when Great Britain increased its public debt by £500bn to rescue its failing banks, the pound lost more than a third of its value against the US dollar, and fourteen per cent against the Euro.
There are, of course, many other elements which influence price discovery on the open market. However, many of these smaller factors can be considered a subdivision of one of the five primary price movers that we have outlined here.
The five fundamental factors provide an excellent starting point for learning to interpret market information and predicting price movements – whether you are just starting out, or you’re a veteran forex trader.