The foreign exchange (forex) market can experience high levels of both liquidity and volatility, which is one of the reasons for it being a popular venture amongst many traders.
As forex trading involves the exchange of global currencies, there are a range of events which can alter the strength of the economy — and as a result, have a ripple effect on the value of currency pairs.
According to the online trading platform Skilling, the following factors (although not limited to) can affect the forex market:
- Interest rates
- Political stability
- Public debt
- Terms of trade
In this article, we’ll break down these top factors, and explore their potential impact on the forex market.
The rate of inflation reflects the overall prices of goods and services over time. Two core indicators which determine the rate of inflation is the Consumer Price Index (CPI) — an average price of a basket of consumer goods — and the Producer Price Index (PPI), which is the average change in prices, over time, received by domestic producers for their output.
The optimal inflation rate for a country is usually 2%. If inflation is too high or too low, it can cause instability in the economy and volatility in the forex market. When inflation rates are low, central banks often cut interest rates, which can lead to a weaker currency.
The interest rate is the percentage charged on the total amount you borrow, or earn on the amount you save. Central banks will raise or lower the interest rates to influence the strength of the economy, as well as consumer spending and borrowing.
Interest rates and inflation are intrinsically linked — interest rates can be lowered or risen to balance the rate of inflation. If inflation rate is high, then interest rates tend to rise. Likewise, when inflation is too low, interest rates usually follow suit.
The interest rate in respect to another country can determine the exchange rate of the relevant currencies. A higher interest rate tends to lead to a stronger currency.
When a country experiences political uncertainty, you can expect greater volatility in the value of its currency.
In particular, you’ll often find the forex market experience fluctuations during elections, as a change in power can have significant effect on the nation’s currency. A new government could see an increase in fiscal spending, or a more reserved approach to monetary policies, which in turn will affect the economy and its currency.
This is the amount of money a government owes to lenders outside of the country — debtors of which can include wealthy individuals, businesses or other governments. It’s usually the preferred option amongst politicians, as opposed to raising taxes.
Public debt, can be a good way for countries to gain funds to invest in their economic growth, as it can improve the standard of living and encourage consumer spending.
However, it needs to be used correctly. If governments take on too much debt, it can cause interest rates to rise and make economic growth a more expensive feat. There needs to be a balance between improving the economy, and keeping interest rates low, in order to keep the nation’s currency stable.
Terms of trade
Terms of trade (TOT) is a representation of the relationship between export and import prices, and takes the form of a percentage. It’s calculated by dividing the price of exports by the price of imports, and then multiplying the figure by 100.
If the TOT is less than 100%, then there is more capital leaving the country than the country is receiving — and vice versa when the TOT is greater than 100%. The TOT can be used as an indicator of a nation’s economic health, as a way to evaluate what has caused the export and import prices to increase or decrease.
Once this factor has been determined, investors can use this analysis to predict the impact on the forex market.
There are a wide range of variables which can have an impact on currency trading, some of which are unpredictable, whilst others can be monitored via an economic calendar. As a forex trader, it’s important to monitor these events and factors.