Forex market trading is not difficult if you have a basic idea on when the foreign exchange of a country will change.
But how would you know that?
Over a period of time, it has been realised that the forex market can be affected by certain macroeconomic factors. In this article, I would take you through some factors that affect the forex market trading.
To read about the basics and essentials of Forex market trading, you can visit this article.
Let’s go through the list now. Here are the 9 Factors Affecting Forex Market Trading
The Political Landscape
An economy grows when the government willingly takes steps to improve the living standard of its populace. Thus, a stable government may be the first sign of an investor-friendly country. It means the economy has fewer roadblocks and higher chances to grow.
How it relates to forex market trading: A trader might buy the currency of a country whose political conditions are stable.
Example in the world of Foreign exchange trading:
News of Brexit led to a dive in the value of the GBP when compared to the US Dollar.1
Inflation Rate
No surprises there. If the country’s inflation rate is relatively lower in comparison to the other, its currency is expected to appreciate in value compared to a currency with the higher inflation rate.
How it relates to forex market trading: An investor would seek to buy a currency where the inflation rates are lower.
Example in the world of Foreign exchange trading:
As you can see in the graph, as the inflation rose in Zimbabwe, its currency value devalued aggressively.2 Thus, the Zimbabwean dollar is not an attractive destination for Forex traders.
Interest Rate
I’d like to begin explaining this with an example of a shopkeeper selling pens to five kids.
Let’s say you are the shopkeeper selling pens for INR 10. Now, five kids come to you with 10 rupee notes demanding a pen, but the problem here is that you only have three pens. One scenario is that you start a bidding war and the one who needs it the most will bid double or triple the price of the pen. But wait! There is another way.
Suppose you realise that two of those kids don’t really need the pen right now. So you tell them to deposit the 10 rupees with you and when you get new stock, you will give it to them. To sweeten the deal, you say that you will give them 1 rupee along with the pen. The two kids agree and your problem is solved.
Granted, this is an oversimplification, but this is the logic whenever the central bank decides that the inflation rate is growing out of control, it steps in to control it by increasing the interest rates and thus, rein in the amount of currency in the market.
An increase in interest rates is a good sign for investors as the currency rate increases due to the increased interest rate for the currency.
How it relates to forex market trading: An investor will gravitate towards the economy with higher interest rates as they increase their rate of return. This increases the demand for the currency and in turn, increasing the exchange rate.
Example in the world of Foreign exchange trading:
The RBI has increased the interest rate to stem the fall of the Rupee. 3
Government Debt
Would you give money to a person who is already in debt? You wouldn’t.
It’s the same concept here, higher the debt of a country, lower are the chances of it attracting foreign capital, which in turn lowers the country’s exchange rate.
How it relates to forex market trading: An investor may see the government debt trend over the years to determine if it is a sound decision to invest in the currency of the country
Example in the world of Foreign exchange trading:
One of the reasons for the weakening of the Indian rupee is the government debt which has not decreased due to the rise in oil prices.
Terms Of Trade (Export Prices To Import Prices Ratio)
Terms of Trade can be addressed as the ratio of Export Prices To Import Prices. If the country’s terms of trade are large, ie they have more exports than imports, the currency will always appreciate and there will be demand for it. This means its currency value will be greater than another country whose Terms of trade are lower in comparison.
How it relates to forex market trading: An investor may like to invest in a country whose exports are greater than their imports.
Example in the world of Foreign exchange trading:
As China’s terms of trade are mostly positive, it is an attractive source for forex trading.4
Speculation
This is not exactly a measurable factor. If there is speculation that the currency rate will increase, other investors will demand more of the currency and its currency rate increases further. The same holds true for the other side.
How it relates to forex market trading: The trick here is to identify a bandwagon effect and make sure you are out of it before the effect wears away.
Example in the world of Foreign exchange trading:
In 2005-06, with low lending rates in the housing market in the US, there was speculation that property prices would rise and this, in turn, would increase the value of the dollar.
The Capital Market
You can get a rough idea of how the economy is doing by seeing the trend of the capital markets. A lengthy dive of the stock market usually indicates low confidence from the investors and thus, can be useful for predicting the currency rate compared to the other country.
How it relates to forex market trading: If the capital markets show an uptrend, it means the currency rate will increase.
Example in the world of Foreign exchange trading:
Since 2005, as the capital market soared in China, the USD/CNY currency pair decreased, signifying that the yuan had strengthened.5 6
Employment Data
Every country releases employment rates periodically. This is another indication of how well the economy is doing. A high unemployment rate means the economy is not growing in line with the population of if the economy has stagnated.
How it relates to forex market trading: A high unemployment rate could lead to a depreciation in the currency value and thus decrease the forex rate of that currency.
Example in the world of Foreign exchange trading:
After the US non-farms payroll report was released in September with an upbeat tone, the US Dollar index (DXY) ie the performance of the US Dollar compared to a basket of foreign currencies increased from 94.95 to 95.35.7
Economic Planning
The monetary and fiscal policy of a country will give you a good idea if it is investor friendly or not. Thus, if the government has plans and incentives in place to attract foreign capital, investors may flock to this country and increase the demand for the particular currency.
How it relates to forex market trading: The country’s currency rate will increase due to significant investments from overseas.
Example in the world of Foreign exchange trading:
After the budget of 2018 was presented, in the domestic market, BSE and NSE saw a downward trend and it was estimated that collectively, 4.6 lakh crore was lost in Indian stocks.
When it comes to forex market trading, the rupee saw a 44 paise fall when compared to the US Dollar.
These are a few factors which every investor should know before starting foreign exchange trading.
After going through this article about various factors that affect forex trading, not only do you know the basics of Forex trading Strategy, but you have also understood how certain factors affect trading in the forex market.
But, why stop here? Let’s try to understand how to evaluate a country’s exchange rate compared to a basket of other countries. Hint: It’s called REER. Let’s head on over to that article right now.
You can enroll for this forex trading strategy course on Quantra and learn to create a value strategy based on fundamentals such as Real Effective Exchange Rate (REER).
Disclaimer: All investments and trading in the stock market involve risk. Any decisions to place trades in the financial markets, including trading in stock or options or other financial instruments is a personal decision that should only be made after thorough research, including a personal risk and financial assessment and the engagement of professional assistance to the extent you believe necessary. The trading strategies or related information mentioned in this article is for informational purposes only.
