Chapter 4
Factors affecting the currencies
There are innumerable factors that impact the price of currencies and for ease these have been divided into subsections that will help you to understand their effect on foreign exchange.
Economic Factors
This is a no brainer; any activity that impacts the economic health of a country is bound to have repercussion on the value of its currency as well. This is the reason why traders in the FX market are always interested in the economic developments of a country and the indicators of its economic well being such as:
The policy: Trade, corporate and business and monetary policies, including state budget and spending make a huge difference to the value of the currency as they impact the chances of the survival of local businesses as well as the influx of foreign investments. Also, a tight rein is kept on the currency price by the central bank of a country through changes in the interest rates. This is done in keeping with the economic policies and goals of the country and it does have a bearing on the rates of the currency.
Budget deficits: When the government is spending more than its making, this does not bode too well for the economy of the country as the nation’s treasury is bound to get depleted. So, it is understandable why the currency prices reflect positively to news of narrowing budget deficits.
Inflation levels: A currency also loses value in response to high inflation rates as it erodes the purchasing power of the consumers. This in turn causes a reduction in the demand, bringing down the value. However, over the short term, the expectation that the central bank of the nation may take steps to curb the rising inflation and will raise the interest rates to do so, does cause the currency rates to rise.
Overall economic health: The myriad of factors that point to a robust economy that is on track for anticipated growth also contribute to stabilizing and raising the value of the currency. Employment levels, GDP, consumer pricing, retail sales and industrial output are just some of the economic figures that will have a direct impact on the performance of a country’s currency. In simple terms, the stronger the economy of the country, the higher will be the value of its currency.
Economic productivity: Increase in trade points to enhanced productivity of the business sector, which also has a positive bearing on currency value.
Natural Factors
Any natural calamity such as floods, earthquake, famine, drought which will have an impact on the agricultural output and/or put a strain on the country’s resources is bound to impact the value of the currency. In fact, depending on the severity of the catastrophe, the ripples of the event may not only be experienced by the country in which the incident occurs but also by the currencies of the other nations in the area. For instance, the volcanic eruptions in Iceland and the movement of ash towards other European countries brought the prices of EUR and GBP crashing down.
Trade related factors
The import and export of goods between countries inevitably leads to demand for the currency of the nations involved in the trade. Deficits and surplus in the trade of services and goods are indicative of the competitiveness of the economy. In fact, the level of trade shows just how much buying activity can be expected for a currency.
When the imports exceed the exports, the country is said to have a trade deficit and this reduces the demand for the nation’s currency. On the other hand, when exports are higher than imports, the nation has a trade surplus and a greater demand for its currency. You will find these figures published by local government offices each month.
Whether it’s a business that is paying for the goods it imports or the government that has to purchase essential supplies such as food grain, oil, power and other natural produces, the impact is that they need to purchase the currency of the country they are buying from. For example, if India buys wheat from the United States, they have to pay for the purchase in dollars.
To facilitate the trade, they have to buy USD from the market by exchanging their own currency which raises the supply of INR (Indian Rupee) in the market. If the demand does not exist for the currency, the rates of INR are bound to plunge. On the other hand, if an American company buys rice from India, the exact opposite effect is seen on the INR which sees an increase in its value.
Political Factors
Central and state governments and their polices and international as well as regional politics and events can all have a profound impact on the value of currencies. The foreign exchange market is quite susceptible to political instability and anticipations about the economic moves of a new government.
While upheavals in the parliament and an unstable government will negatively impact the value of the currency, the expectations that a new government will create a more business friendly environment can send the prices of the currency of a country through the roof. For instance, the destabilization of the central government and the numerous military coups in Pakistan have managed to exert significant downward pressure on its currency.
Investor Psychology
While the fundamental factors explained above can have a long standing impact on the rates of currencies, one cannot discount the ramifications of investor sentiment on the market either. At the end of the day, those orders are placed by a feeling, thinking man/woman who is as vulnerable to panic selling and anticipation buying as the other guy. Some influences of market psychology on currency prices are:
Flight to safety: This is a capital investment move that is motivated by the need of investors to put their money on assets that are considered safe haven in response to unsettling international events. For instance, the demand for currencies and assets that are considered safe, such as USD, CHF and gold, increases during times of geopolitical turmoil and economic uncertainty.
Buying on rumor and selling on fact: You may have heard terms such as overbought and oversold used in reference to financial markets. This is a market phenomenon in which the prices of currencies react to investor moves which are based on the anticipation of a particular event occurring. Typically, once the incident that was being expected comes to pass, the market moves in the exact opposite direction. This is a clear-cut example of how investors link outside occurrences to currency prices.
The release of economic numbers: Undoubtedly, economic numbers such as that of employment, industrial production and GDP are representative of fundamental factors that can create long term currency trends.
However, these numbers often cause a sharp rise or fall in the prices of currencies when they go above or fall below expectations.
Technical trading: Many investors will follow certain trading strategies and methodologies, if a large group of traders takes a certain position based on the same strategy that is considered to work in certain situations, such as the development of certain chart patterns, this is likely to impact the market moves over the short term.
Speculation: The majority of the traders in the foreign exchange market are speculative investors, meaning those who trade for short terms. So, when a certain prediction starts making the rounds of the market, this can create a buying or a selling frenzy depending on the rumor in question. So, when a few FX stalwarts predict that the rates of a certain currency will rise, the other traders may follow the herd mentality and this will undoubtedly raise the demand for that particular asset.
Mergers and Acquisitions
This is not the most important factor on our list. Yet, it is known to impact currency prices. Although microeconomic developments seldom impact the FX markets, the underlying dynamics of a particularly large merger or acquisition deal can exert strong, short term pressure on the currency that is involved in the trade.
For instance, in 2006, all the fundamentals were standing against the CAD, with the economy of Canada showing a great deal of weakness. Hence, the price of CAD should have tumbled, yet the USD/CAD was held
at an all time low since there was a huge demand for Canadian corporate assets among Middle Eastern, Asian and European buyers.
The Impact of Non-Farm Payrolls On Trading
Possibly the single most important figure when it comes to news trading in the FX market, the non-farm payroll numbers or NFP creates a conspicuous impact on currency prices, particularly pairs that involve the USD, every time it is released.
The NFP is an important indicator of the economic health of the United States as it represents 80% of the American workforce. These are people who are not state or federal employees, do not work in the agriculture sector or in private households and are not nonprofit workers employed to care for others.
The figure is released on the first Friday of every month by the Bureau of Labor Statistics, and every month it acts as a short term trigger for market movement. Since the NFP represents the number of job creation in the American economy, which in turn is a reflection on consumer spending that is the driving economic force, its impact on the US Dollar is understandable.
When the NFP overshoots the anticipated mark, it translates to an improving/growing US economy, which has a positive impact on USD. Also, this puts pressure on the interest rates in the country. An increase in the interest rates makes dollar holdings more profitable and creates a greater demand for the greenbacks.
NFP and Forex Trading
The Nonfarm Payroll data is a leading indicator because it reflects information from the previous month. The release of the number creates a significant amount of volatility in the market. So, trading on this news is not for the faint hearted. As stated above, if the NFP goes above the market anticipation, the prices of the USD also move in tandem. However, if it undershoots the mark, the rates of the currency fall within a few minutes of the NFP’s release. As a newbie trader, you may want to wait till the market calms after the release of the NFP, before taking a position.
If you would like to play the market on this important economic factor, a rise of about 40,000 jobs is a clear signal for entering the market. A higher change will undoubtedly create more unique trade opportunities, given the extreme volatility of the market. Although the impact of the NFP is felt throughout the day, typically the strongest reaction is seen within the first 15-30 minutes of the information being made public.
Where to find Forex newsworthy information?
There are several sources for information on economic changes and events that impact the currency markets. Although charts will be made available by the brokerage house that you deal with, for additional news and reports on expected happenings, you can go to: