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Similar to any other market 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 inflation, interest rates, growth and macroeconomic risk.

Here are all the major factors affecting the fluctuations of global currencies.

1. Interest Rates

The interest rates of an economy are determined exclusively by the Central Bank (FED in US). When the interest rates of a Forex currency are increasing, that means that more investment funds are attracted and buy that currency in order to achieve higher interest return. On the other hand, when interest rates are decreasing a Forex currency is less attractive to investment funds and thus it is expected to fall against other currencies. 

Interest Rates Correlation

1) When Interest Rates ↑ then the Forex Currency ↑

2) When Interest Rates ↓ then the Forex Currency ↓ 

 

2. Economic Growth (GDP)

Economic growth which is measured by GDP change (%) is a key factor determining the demand of a Forex currency. High growth means that an economy is doing well, especially if growth is accompanied by relative low inflation. Usually, growth 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.

Economic Growth Correlation

1) When GDP ↑ then the Forex Currency ↓

2) When GDP ↓ then the Forex Currency ↑

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 different is negative, the country has a trade deficit, and that is bad news for the demand of its currency.

Moreover, a domestic currency reflects the government economic policy regarding the domestic balance of payments. For example, when the government policy aims to shorten the trade deficit imposes restrictions and tariffs to imports or subsidies 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 zero or even negative.

Trade Balance Correlation

1) When Trade Balance is positive then the Forex Currency ↑

2) When Trade Balance is negative then the Forex Currency ↓

 

4. The rate of inflation

The inflation rate of an economy has a very strong impact on the value of Forex currency. When the level of prices increase in an economy, each unit of a currency can buy fewer goods and services, and thus the purchasing power of money is decreasing and consequently the real value of the domestic currency is decreasing too. On the other hand, lower inflation increases the purchasing power of money and the real value of a domestic currency is increasing against foreign currencies.

Inflation Correlation

1) When Inflation ↑ then the Forex Currency ↓

2) When Inflation ↓ then the Forex Currency ↑

 

5. The Rate of Unemployment

At periods 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 to lower consumer confidence and lower expectations about the future economic growth and consumer spending.

Unemployment Correlation

1) Unemployment ↑ then the Forex Currency ↓

2) When Unemployment ↓ then the Forex Currency ↑

Measuring Unemployment

The Non-Farm Payroll (NFP) is an indicator issued the first Friday of each month and it is used to measure the US employment. »United States Department of Labor

 

6. Political stability

Political stability is a very important factor regarding the future value of a Forex currency. Political uncertainty increases the risk of an economy and furthermore it reduces the consumer and the investor confidence. When there is no political stability the potential of future economic growth is jeopardized. Furthermore in periods of global political uncertainty investors are after “Safe-Heavens”. That means that they will exchange weak currencies for strong currencies like US dollar or Euro.

Political Stability Correlation

1) Political Stability ↑ then the Forex Currency ↑

2) Political Stability ↓ then the Forex Currency ↓

 

7. Central Bank Actions / The Monetary Policy

The monetary policy and the strategy of the Central Bank of a state can determine in a high extend the current and future value of a Forex Currency. As it is already mentioned a Central Bank may interfere by maneuvering interest rates, but also in many other ways. For example an intervention may involve the purchasing of domestic bonds (i.e. the European Central Bank during 2011-2012).

 

8. Market factors

Market factors may affect also the value of a Forex 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 affected highly by the market prices of energy commodities and thus their currencies are reflecting and incorporating those price changes very quickly.

 

9. Natural disasters

Serious natural disaster may disturb the growth potential of a country or even increase the amount of government debt. Furthermore, if a natural disaster has a strong impact on the growth potential of an economy it is likely that the Central Bank will decrease the level of interest rates in order to achieve faster recovery. Natural disasters have an unfavorable impact to domestic currency valuation.

 

10. Currency Speculation

Currency speculation can affect highly the real value of a Forex currency. Large institutional speculators (i.e. hedge funds) have the power to bet against a particular currency aiming profits. For example in 1992 George Soros made over 1 billion USD by short selling British Sterling.

 

The Role of Consumer Spending

The value of a currency is highly affected by the overall level of the consumer spending. When an economy enters 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 deckling against currencies of stronger economies.