Factors Affecting Exchange Rates
Similar to any other financial price, the price of an exchange rate is determined by the forces of demand and supply. The price of an exchange rate reflects many economic and non-economic factors. The most important factors are interest rates, inflation, growth, employment, and political risk.
Here are all the major factors affecting the fluctuations of global currencies.
1. Interest Rates
Central Banks and Interest Rates
The interest rates of an economy are adjusted by the domestic monetary authority, such as FED in the US and ECB in the Eurozone. When the interest rates of a particular currency increase, more investment funds are attracted and buy that currency to achieve a higher interest return. On the other hand, when interest rates are decreasing an exchange rate is less attractive to investment funds and thus it is expected to fall against other currencies.
Interest Rates Correlations
1) Interest Rates increase ↑ → market liquidity and inflation are expected to decrease ↓ → the domestic exchange rate increases ↑
2) Interest Rates decrease ↓ → market liquidity and inflation are expected to increase ↑ → the domestic exchange rate decreases ↓
2. Economic Growth (GDP)
Economic growth as measured by GDP changes is a key factor determining the demand for an exchange rate. High growth means that an economy is doing well, especially if growth is accompanied by relatively low inflation. Usually, growth of more than 2.5% is followed by high inflation. Additionally, high growth means low unemployment and higher national income, in other words, high growth means higher consumer spending. Overall economic growth leads to domestic currency appreciation.
Economic Growth Correlations
1) GDP increases ↑ → the domestic exchange rate increases ↑
2) GDP decreases ↓ → the domestic exchange rate decreases ↓
3. Trade Balance
The balance of trade is the difference between the value of exports and the value of imports. If this difference is positive, the economy produces a trade surplus and that it is favorable for the domestic currency. That is happening as foreign buyers are obligated to exchange more of their home currency than domestic sellers. If this difference is negative, the country has a trade deficit, and that is bad news for the demand for its currency.
Moreover, a domestic currency reflects the government's economic policy regarding the domestic balance of payments. For example, when the government policy aims to shorten the trade deficit imposes restrictions and tariffs on imports or subsidies on exports. But usually, this kind of government intervention results in retaliation measures from other countries and thus the long-term effect for a currency may conclude to zero or even negative.
Trade Balance Correlations
1) Trade Balance is positive → the domestic exchange rate appreciates ↑
2) Trade Balance is negative → the domestic exchange rate is losing value ↓
4. Inflation Rate
Inflation plays a major role in Foreign exchange trading. When the level of prices increases, each unit of a currency can buy fewer goods and services, and thus the purchasing power of money is decreasing. On the other hand, higher inflation means higher growth and higher interest rates, this is why usually when inflation grows the domestic currency is increasing against foreign currencies.
1) Inflation gets higher ↑ → interest rates are expected higher ↑ → the domestic exchange rate appreciates ↑
2) Inflation gets lower ↓ → interest rates are expected lower ↓ → the domestic exchange rate is losing value ↓
5. Unemployment Rate
When unemployment increases the jobless workers have less income to spend on goods and services and consequently the overall consumer spending is decreasing. Additionally, higher unemployment results in lower consumer confidence and lower expectations about future economic growth and consumer spending. But what matters in the Foreign Exchange market is that higher unemployment pushes interest rates down.
1) Unemployment gets higher ↑ → interest rates are expected lower ↓ → the domestic exchange rate is losing value ↓
2) Unemployment gets lower ↓ → interest rates are expected higher ↑ → the domestic exchange rate appreciates ↑
- The Non-Farm Payroll (NFP) is an indicator issued on the first Friday of each month and it is used to measure US employment. » The US Department of Labor
6. Consumer Spending
Exchange rates are highly affected by the level of consumer spending. When an economy enters a recession, consumer spending tends to decline, and consequently, the trading sentiment for the domestic currency is declining too. As an overall outcome, the domestic exchange rate is declining against currencies of stronger economies.
Consumer Spending Correlations
1) Consumer Spending gets higher ↑ → interest rates are expected higher ↑ → the domestic exchange rate appreciates ↑
2) Consumer Spending gets lower ↓ → interest rates are expected lower ↓ → the domestic exchange rate is losing value ↓
7. Political stability
Political stability is a very important factor regarding the future value of an exchange rate. Political uncertainty increases the risk to the economy and reduces consumer and investor confidence. When there is no political stability the potential for future economic growth is jeopardized. Furthermore in periods of global political uncertainty investors prefer “Safe-Heavens”. That means that they will exchange weaker currencies for stronger currencies, like the US dollar and Euro.
Political Stability Correlations
1) When there is Political Stability → the domestic exchange rate appreciates ↑
2) When there is NO Political Stability → the domestic exchange rate is losing value ↓
8. Long-Term Monetary Policies
The monetary policy and the long-term macroeconomic strategy of a major Central Bank can determine to a high extent the current and future exchange rate. As it is already mentioned, Central Banks may interfere by maneuvering interest rates, but also in many other ways. For example, an intervention may involve the purchasing of domestic bonds (e.g. the European Central Bank during 2011-2012).
- "Never Trade against a major Central Bank, unless you are George Soros"
9. Commodity prices
The price of widely used commodities may affect the value of an exchange rate. For example, when the price of oil goes up, oil-exporting currencies are moving higher against oil-importing currencies. Countries like Norway, Russia, and Canada are highly affected by the prices of energy commodities and thus their currencies are reflecting and incorporating those price changes very quickly.
10. Natural disasters
Serious natural disasters may disturb the economic prosperity of a country and increase government deficits. Furthermore, a natural disaster can have a strong impact on growth, and thus the Central Bank will likely decrease the level of interest rates to achieve faster recovery. Lower interest rates mean domestic currency depreciation. Overall, natural disasters have an unfavorable impact on the domestic exchange rate.
11. Currency Speculation
Currency speculation can highly affect exchange rates, especially the exchange rate of a small country. Large institutional speculators (i.e. hedge funds) have the power to bet against a weak currency aiming for profits as it goes down. For example, in 1992, George Soros made over 1 billion USD by short-selling the British Pound Sterling.
• Factors Affecting Forex Currency Fluctuation