No financial marketplace comprehends as much of what is proceeding in the global trading community at any given time as foreign currency exchange, but in the end, Forex prices are a result of supply and demand forces.
The cost of one currency relative to another is constantly shifting due to the forces of supply and demand. So it is safe to say that a currencies value is not influenced by one single force, but by several. These forces generally fall into three categories: Market Psychology, Economic Factors and Political Conditions.
Market Psychology
One of the most difficult aspects of the Forex markets to comprehend is the influence market psychology can have on the price of a currency. Since it doesn’t involve financial statements or central bank policy decisions, Forex traders have a hard time putting their fingers on it.
Sometimes it’s only the way a central bank phrased its policy statement or the tone of a speech, but Forex traders quickly turn “hawkish” or “dovish” in their sentiment and thus exert the force of market psychology on the currency markets.
Falling under the category of market psychology are the following:.
- Buy the rumor, sell the fact: It is the tendency for the cost of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction.
- Flight to Quality: Forex investors often seek the protection of a safe haven currency during times of unsettling international events. During this event investors demand currencies perceived as stronger over their relatively weaker counterparts.
- Flight to Safety: When there is clarity in the markets, investors will seek the currency offering the highest yield. This is generally known as a “risk on” scenario. In other words, investors are willing to take on additional risk to capture a higher reward. During times of uncertainty investor sentiment may revert to a “risk averse” mentality where they sell the higher yielding or “risky” currencies in favor of the lower-yielding or ‘safer” currencies.
- Long-term trends: Whether because of economic or political trends, very often certain currencies move in long, pronounced trends attracting the attention of long-term cycle investors. Since there is no real business cycle or growing season affecting currency prices, certain types of investors who have the staying power look to exploit the long-term tendencies of currencies.
- Economic numbers: Although all economic numbers have some impact on the Forex markets over the short-run, some numbers wield more powerful influences on the movement of the markets. These numbers typically rotate giving each a chance to share the spotlight. An example would be traders putting more emphasis on a GDP report at this time than a Retail Sales report. The easiest way to understand this is to assume that trader tastes and preferences change.
Economic Factors
These include economic policy, disseminated by government agencies and central banks, and economic conditions, generally revealed through economic reports.
- Economic policy: comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government’s central bank influences the supply and cost of money, which is reflected by the level of interest rates).
- Economic conditions: including inflation levels and trends.
- Economic growth and health: Reports such as gross domestic product (GDP), employment levels, retail sales, capacity utilization and others, detail the levels of a country’s economic growth and health. Investors tend to demand the currencies with the best economies.
- Government budget deficits or surpluses: Simply stated, narrowing budget deficits are usually good for a currency’s value. Widening government budget deficits are generally bad.
- Balance of trade levels and trends: Forex investors watch balance of trade levels and trends very carefully. Surpluses and deficits are perceived as indicators of the competitiveness of a nation’s economy.
Political Conditions
- Internal, regional, and international political conditions can have a profound effect on currency prices.
- Political upheaval and instability can have a negative impact on a nation’s economy.
- The rise of a political faction that is perceived to be fiscally responsible can have a positive effect.
- One country in a region may spur positive or negative interest in a neighboring country and, in the process, affect its currency.
- Election results and shifts in political party power.
