FOREX What Influences Exchange Rates

             What Influences Exchange Rates

Before we look at the factors and players that influence the exchange rates, we must understand how these rates affect economies.

First, exchange rates influence the trading relationship between countries, which is a major concern for central banks.

Let’s look at the EUR/GBP currency pair.

If the British pound increases in value against the euro, it makes British exports more expensive for European buyers.

For example, when the British pound appreciates, it becomes more expensive for a car dealer from France to buy Land Rovers built in the UK as it would require more euros to buy the same amount of pounds. Consequently, the manufacturer of Land Rover could get fewer sales and the UK exports would decrease as many UK manufacturers as possible export overseas.

A higher pound would also negatively affect British tourism, as almost everything would become relatively more expensive in Britain for tourists and foreign partners. The overall balance of trade would decrease if the currency value were higher. 

On the other hand, if the value of the British pound would go down, it would make the British exporters more competitive, and the overall exports would increase.

Therefore, countries are constantly trying to sustain a healthy currency exchange rate to help their exporters.

It's a very challenging task because a low currency rate can be good for exporters, but it is usually not so good for businesses that import goods because those goods will become more expensive for them. 

As you see, central banks are in a constant struggle to achieve and maintain an exchange rate that would be good for all participants of their economy. And it's not an easy task as the different market participants have different needs.

The golden rule of economic data reports

Forex traders closely follow economic calendars. Forecasts and reports about such data as inflation numbers, unemployment rate, GPD, etc. - can significantly influence currency prices.

And here is the fun part: 

Markets don't wait for the actual reports to come out. They start reacting and moving based on expectations and forecasts alone.

If the forecast promises positive growth and the actual data comes out even better than forecasted, it amplifies the rise of the currency even more. 

However, if the actual data comes out worse than expected, it can create strong downward pressure on the currency.

Here is the rule to remember with financial reports:    

                                

                                          
To illustrate this rule, let’s look at an economic calendar and compare the GDP growth indicators (month-to-month) of the U.S. and Canada and see how these indicators would influence the USD/CAD exchange rate.

For example, let’s assume that all other economic indicators for both countries are the same. Can you guess, by looking at the illustration above, which currency will rise in value against the other?

As you can see, both the U.S. and Canada have the same actual GDP growth rates of +0.4%, but that doesn’t mean that the USD/CAD currency rate will stay the same after the release of this data! 

The winner, in this case, is the country that surpasses the forecasts — which is the U.S.

Canada’s actual numbers were worse than expected so market participants will take this as a bad sign for the Canadian economy and the CAD will decrease against the USD.

           9 key indicators that drive exchange rates

Here are the most important factors and economic indicators influencing the exchange rates: 

Interest rates, Inflation, Deflation, GDP growth rate, Employment Statistics, Trade balance reports, Political events, Military conflicts, Quantitative easing

You must remember that these factors are relative and should be compared between the two countries of a currency pair.

Furthermore, there are factors like interest rates and target inflation that are planned well in advance and reported instantly through news outlets like Bloomberg, Reuters, and economic calendars.

In forex, headline economic data really does move the markets, and currency traders can take advantage of this fact.

1. Interest rates

Interest rates are one of the most important indicators driving both forex and stock prices. If money makes the world go round, interest rates make the money go round. Interest rates are set by the reserve banks and act as benchmarks for financial institutions.

A higher interest rate means that borrowing money is more expensive long term because the interest you pay back to the borrower is higher, and it also makes saving more attractive because you can yield a higher interest in your account.

For example, the higher the interest rates are in the U.S., relative to other countries, the more attractive it is to deposit money in the U.S. by buying US bonds.

Therefore, a country with the highest interest rates attracts more foreign investment, and its currency rate drives up.

How do interest rates work?

If the economy is in a downturn and companies are nervous about the future and are reducing investments, a central bank can lower the overnight rate that it charges smaller banks for borrowing money.

This is often called the benchmark interest rate. If the central bank reduces the benchmark interest rate, it will usually drip down to commercial banks who then reduce the interest rates they charge to their clients (private persons and businesses).

Lower interest rates make it cheaper for people to buy cars and houses and for businesses to get credit. This, in turn, stimulates investment and spending, which then leads to economic growth. 

 Cutting interest rates

What happens when interest rates are being cut?

Cheaper borrowing. If loans are cheaper, businesses and consumers will spend more, thus “warming” the economy.

Increased motivation to spend money. Lower interest rates mean smaller returns from holding money in deposits, so consumers and businesses will be motivated to spend the money rather than just save it. 

Lower mortgage payments. When banks have access to cheaper money, they will also lower the costs of mortgages and lower requirements.

Real estate prices rise. When more people can afford to buy a house, the prices will go up due to the increased demand. This again will create more wealth and more wealth/ money in circulation is also good for a weak economy.

As you see, interest rates affect each and every market participant.

2. Inflation

Inflation is sometimes called “the pulse of the economy". Here is an interesting chart showing how prices changed from 1997 till 2017.

   

 Inflation is measured as an annual percentage increase in prices for a defined set of goods and services.

What creates inflation? Inflation normally occurs if there is more money in the market than goods.

When more money is chasing the same or smaller amount of goods, the prices rise. These situations are quite normal in growing economies where people start earning and spending more but the production or import cannot keep up.

Another cause of inflation can be the increasing costs for businesses. For example, when the prices of oil and gas go up, it affects the end price of nearly every product and drives inflation up.

Raising interest rates

Raising interest rates, obviously, has the opposite effects of cutting them, so we will not go through all the same points. 

When the markets are expecting an interest rate increase in the U.S., the U.S. dollar tends to rise in value against other currencies that have lower interest rate forecasts.

The exception to this rule is when a country increases the interest rate to save a falling currency.

Who controls interest rates?

The interest rates are controlled by the central banks. Here are 8 most influential Central Banks:

• U.S. Federal Reserve Bank (USD) 

• European Central Bank (EUR)

• Bank of England (GBP)  

• Bank of Japan (JPY) 

• Swiss National Bank (CHF) 

• Bank of Canada (CAD) 

• Reserve Bank of Australia (AUD)  

• Bank of New Zealand (NZD)

Look for the small cues!

To maximize profits, experienced traders do not wait for the announcement of an interest rate hike or cut.

To be ahead of the curve, many traders often look for small cues in wording and body language in the FED chairman's speeches. Even the smallest hint of a rate hike or drop can move the markets significantly.

Dovish policy

If the FED chairman says something like: "We see that the economy is showing signs of weakness" it is considered a dovish signal that might result in lowering interest rates soon. And the U.S. dollar might fall due to such a statement.

A dovish central bank is typically characterized by a willingness to lower interest rates or undertake other actions that stimulate spending and investment.

Hawkish policy

A hawkish central bank, on the other hand, is one that adopts monetary policy measures that are intended to keep inflation in check, even if doing so may lead to slower economic growth or higher unemployment. 

A hawkish policy often involves raising interest rates. Raising the central bank's benchmark interest rate makes borrowing more expensive for businesses and consumers, which can slow down spending and investment, thus lowering inflation.

3. Deflation

Deflation is the opposite of inflation. Deflation means that the general level of prices is decreasing. Falling prices sound awesome, right?

Not if they last for a long time! A single month of deflation is not bad......But if deflation is prolonged, it comes with a strange deflationary psychology: consumers and companies stop spending money as they hope that the items, they want to buy will soon become even cheaper.

This creates a chain reaction that often leads to stagnation and crisis.

A painful example was Greece in 2014/15:

• As the crisis and austerity measures continued, consumer demand weakened.

• Businesses were forced to cut prices.

• Consumers stopped spending as they anticipated prices to fall even more.

• Businesses had no income and had to lay off workers.

• With increasing unemployment, the situation worsened.

• As the spending didn’t resume, many more businesses went bankrupt.

• The Greek government debt continued to grow as tax revenues shrunk.

What does this tell us? Chronically decreasing prices is not a good thing for the economy. An optimal state for an economy has been considered to be when inflation is around 2%. A small annual price increase is a sign that the economy is growing at a controllable pace.

4. GDP growth rate

Gross Domestic Product growth (GDP) is an important indicator to determine the health of a nation’s economy. The GDP represents the value of all finished products and services produced by a country, usually on an annual basis.

The forex market usually looks at the percentage change in GDP on a quarter-to-quarter basis. If the annual increase in GDP is at 3.0% - 3.5%, it indicates a healthy economy.

If the rate is higher, it can be a signal that excessive inflation is forming. A smaller rate and a declining rate in general signal an economic downturn with decreasing demand from consumers and rising unemployment.

If the GDP growth is negative for 6 months, it is considered a sign of a recession. For example, if the European GDP rate is released and the number is higher than forecast, this would generally drive the value of the euro higher.

Conversely, if the number comes out lower than forecasted, it will most often affect the euro rate negatively.

5. Employment Statistics

The employment statistics are usually reported as the “unemployment rate". It measures the total workforce of a nation that was unemployed during the previous month. Changes in the unemployment rate can have a sharp effect on currency rates, especially if the results differ substantially from the numbers the analysts were expecting.

 If the actual unemployment rate is lower than forecasted, it is good for the currency, and vice versa.

6. Trade balance

The trade balance is the difference between the exported and imported goods and services during the reported period. 

When exports exceed imports, it is called a trade surplus, which is a good sign for the currency.

Trade surplus means that other countries are buying products and creating demand for the local currency.

When the imports exceed exports, it is called a trade deficit and that is bad for the local currency.

A trade deficit means that there is a big demand for foreign goods, which are purchased with foreign currency, thus strengthening that foreign currency and weakening the local one.

7. Political events

Political events can have dramatic effects on currency rates. The most significant political events are elections, referendums, and different scandals.

If a country has an unstable political environment, the value of its currency will tend to decrease as investors and forex traders try to avoid uncertainty.

Elections

Elections usually create uncertainty about the future of a country. When the leaders of a country change, it often comes with a different approach to fiscal (taxes and government spending) and monetary (interest rates, bank reserve settings) policy, both of which have a direct impact on currency rates.

In the case of upcoming elections, forex traders keep an eye on the pre-election polls to get an idea of the possible scenarios.

If the upcoming leader is seen as economically responsible, then the currency rate will appreciate, as traders will go long on the currency.

On the other hand, if the polls show majority support for a person who is seen as a threat to the economy, the currency value will decrease as traders and investors will sell out the currency.

Referendums

Lately, referendums have become quite popular, creating opportunities for currency traders to profit from them.

Here are some examples of referendums with global impact:

• Will Scotland be independent of the United Kingdom?

• Should Greece accept the bailout from Europe?

• Should the United Kingdom leave the European Union?

When the preparation for the referendum on Scotland’s independence started, it decreased the value of the pound. The pre-referendum polls showed close results. Therefore, investors started selling their pound assets fearing that the United Kingdom’s economy would suffer if Scotland separated. This was a good opportunity for forex traders to go long on EUR/GBP as the euro rose against the pound till the very day of the referendum.

Scandals

When a corruption scandal erupts at the government level, it can impact the economy of the country either by sparking protests, work stoppages, or even triggering unexpected elections. Even if there is a chance that protests might result in improvements to the political and economic situation, the mere instability of such events negatively impacts the currency rate of the country.

8. Military conflicts

What would happen to the Australian dollar if China invaded Taiwan?

The Australian dollar would fall against all other major currencies, as investors would want to take their money as far as possible from the war. And also because the Australian economy is heavily connected to China.

This seems logical, right?

But here's the trick: you don’t even need an army to cross a foreign border to cause such an effect.

Just the threat of a potential military conflict tends to destabilize the currencies of the involved nations.

This happens because investors hate instability, so they will pull out their resources from these markets as quickly as they can.

A strong example of this was when Qasem Soleimani, a high-ranking Iranian military official and the leader of the Islamic Revolutionary Guard Corps' Quds Force, was eliminated in an air strike ordered by the United States government.

You wouldn't have guessed, but this attack resulted in the fall of North Korean currency.

How come? Because investors feared that such a move from the USA could signal that they have little tolerance towards nations that they deem hostile. And North Korea has been at the very top of the hostile country list for a long time. So, a big group of the few investors who left North Korea decided to take their assets somewhere safer.

As you see, the whole world is very interconnected.

9. Quantitative Easing

Quantitative Easing (QE) might sound like rocket science, but in essence, it works similarly to an interest rate cut used by central banks to revitalize the economy during and after serious recessions.

When the crisis of 2008 - 2009 started, many central banks slashed their overnight interest rates to help the economies recover.

Many of them had to cut the rates close and below zero, but even that failed to revive economic activity.

How much money is involved in a QE?

On January 21, 2015, the European Central Bank announced a QE program during which it would purchase 50 billion euros of bonds per month, for a total of 1.1 trillion euros!

This announcement sent the euro to an 11-year low against the U.S. dollar.

Many forex traders who shorted EUR/USD before the announcement made nice profits.