Part V: What Influences Forex Prices?
Foreign
exchange rates are both a market unto themselves and an influence on
the fundamental situation of other markets. They reflect the strength
or weakness of an economy and are a factor in it. This kind of
duality can create a truly mind-spinning situation at times. There
are a few things, however, which directly influence forex prices.
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Interest Rates
Most people will think first of interest rates when the idea of
evaluating one currency against another comes in to play. They are
indeed a major part of the forex market equation. Interest rates on
the one side determine the “yield” of a currency, while on the other
side can be viewed as a barometer of the position of a country’s
economy (or of an economic region like the European Union).
To that end, the same sorts of things which
impact interest rates also play a part in forex prices. Inflation, or
rather the expectations for inflation, is the single largest influence
on interest rates. But even there it is not a clean scenario. If
interest rates are rising because of strong economic growth leading to
mild concerns about inflation, that tends to be a positive for a
currency. On the other hand, if rates are rising because signs of
inflation are starting to show (or significant inflation already
exists), that can be a negative.
Keep in mind that the value of a currency is a
reflection of its buying power. Inflation erodes that, so a country
seeing high rates of inflation will generally have a weaker currency.
This can easily be seen in the emerging markets where interest rates
are often quite high, but the the currencies remain weak because of
issues with inflation.
Trade
The forex market exists first and foremost to
facilitate trade, and trade is a huge determinant in the value of a
currency. The more a country’s goods are in demand, therefore
requiring buyers to convert their currencies in to the exporter’s
currency, the stronger it will be. It is a simple supply and demand
equation. More demand means higher values.
Because of this influence, forex traders keep a
keen eye on trade data. These figures, of course, are historical by
the time the market sees them, meaning the trade transactions have
already happened and their push or pull on a currency’s value have
taken place. What traders want to know, however, is if money is
flowing in to or out of a country.
Capital Flows
Capital flows are a parallel to trade. Rather
than representing the value of goods and services being exchanged,
they indicate the investment of capital in to a country. Investment
works the same way as trade. A country receiving a lot of investment
money is similar to a country selling a lot of goods on the trade
market. It’s currency is in demand.
What creates capital inflows? Higher relative
real interest rates (rates adjusted for inflation) is one thing.
Opportunities for investment profits in a country’s stock market is
another. Capital seeks returns. It will go where it thinks it is
going to get the highest one for a given level of perceived risk.
Capital flows are seen in the balance of payments
information released by the government. Traders look at it the same
way they do the trade data. Is money coming in or going out of the
economy?
Reserve Currency
You may have heard that the US Dollar is a
reserve currency, which means other country’s keep a supply of Dollars
on hand as a safety measure against adverse conditions. This helps
provide demand for the Dollar, even when the items noted above would
suggest a negative scenario.
A similar situation can be found in the fact that
global commodities like oil and gold are denominated in US Dollars.
Anyone buying them must exchange their own currency for Dollars in
order to make a purchase, providing an added layer of demand for the
US currency.
Comparison
The thing which makes the forex market so complex
is the fact that when one is trying to perform the kind of fundamental
analysis we have discussed here, it is a multisided equation. Looking
at one country is not enough because a currency is valued and traded
against an array of others, all of which have their own sets of
considerations.
The comparison for a stock trader would be a
spread trade in which one is going to buy one company’s shares and
sell those of another related one in a bet that the former outperforms
the latter. Obviously, you would buy the stock of the firm with the
better fundamental outlook and sell the one which looks weaker.
This multiple analysis is enjoyable to some, but
is probably the biggest factor behind the extreme popularity of
technical analysis among forex traders.
Conclusion
In this 5-part introduction to the forex markets we have covered all of the key
information you need to get yourself up and running, frankly with more know-how
than many people just getting started. The next step is to start applying what
you know. That means trading. You will want to start off with one of the many
available demo trading platforms as you get your feet wet. Given the ready
availability of low minimum accounts in forex, though, it is not a bad idea to
get in to live trading with a small amount of money as soon as you can because
there is definitely a different between doing it for play and doing it for real.
Best of luck!