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Many traders new to the forex market reasonably wonder what causes currency price changes. As is the case with most markets, the prevailing exchange rate represents the rate at which supply and demand factors find balance. As a result, the simple answer is that when there are more buyers than sellers in the market the market rate moves up, and when there are more sellers than buyers it moves down.
Unfortunately, determining why this balance of supply and demand has shifted in the first place can be quite complex and often requires an advanced understanding of the economic and political environment of the countries issuing each of the currencies involved. Some of those forex market-moving factors are listed and their effects explained below.
Exchange Rate Movement Factors:
A list of the main fundamental factors that forex market participants commonly assess when performing fundamental analysis follows:
- Interest Rate Differentials - exchange rate trends generally move in favor of the currency that has the higher interest rate of the pair. Central banks of the countries generally set these benchmark interest rates, so any comments made by interest rate policymakers indicating a tighter monetary policy would tend to benefit the currency of that country relative to that of others with looser monetary policies. In the forex market, interest rate differentials are somewhat analogous to continuous dividends for stocks. Profits generally accumulate over time as a trader holds a long forex position in the currency with the higher interest rate, although losses accrue when a trader holds a long position in the currency with the lower interest rate overnight or longer.
- Growth Rate Differentials - the currency market tends to trend in favor of the currency of the country with the higher growth rate because having a higher growth tends to imply a stronger economy and higher interest rates. Employment data is also a very important factor in how the market moves, with an improvement in jobs generally being positive for that currency.
- Political Influences - the currencies of countries that have more stable government politics tend to be favored over those currencies of less stable countries. The market also tends to favor currencies from countries whose governments demonstrate greater fiscal responsibility. This relates to government spending on social programs and defense, and is affected by whether its budget is balanced or running a substantial deficit.
- Commodity Prices - Higher oil prices tend to hurt the currencies of the largest oil importers like Japan and the United States, but they tend to help the currencies of Canada and the United Kingdom because those countries produce oil. Furthermore, a higher gold price tends to hurt the U.S. Dollar and the Japanese Yen, but often shows a positive influence on the Australian Dollar because Australia exports significant amounts of such precious metals.
- Commodity Prices - Higher oil prices tend to hurt the currencies of the largest oil importers like Japan and the United States, but they tend to help the currencies of Canada and the United Kingdom because those countries produce oil. Furthermore, a higher gold price tends to hurt the U.S. Dollar and the Japanese Yen, but often shows a positive influence on the Australian Dollar because Australia exports significant amounts of such precious metals.
- Geopolitical Events - The currencies from countries at peace and that have stable economic and political structures tend to be preferred over those currencies whose issuing country is at war or otherwise unstable or threatened.
- Supply and Demand Effects - Large capital flows into one currency at the expense of another, which can arise from large transactions made by international corporations or a big fund manager?€™s portfolio shift out of one country and into another, can often move an exchange rate substantially to benefit the currency in the greater demand.
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