What exactly are the factors which determine the strength of one currency against another and, consequently, the direction of the foreign exchange (FOREX) market? Is there a precise formula for plugging in various factors and getting a foolproof timetable and map for currency movement? This article highlights certain factors relied upon by experienced currency traders in formulating a trading plan.
It is in understatement to say that every currency trader wishes to know which direction the FOREX market will be moving next in order to maximize profits. While no guru can prediction market direction with flawless accuracy, probability of market movement may be a more realistic aim. Innumerable strategies, trading models, and software packages have been built in response to the insatiable desire to harness the erratic FOREX. As in any arena, some approaches are more successful than others. Regardless of which approach is used, they all must realistically defer to several very germane factors.
State of the Economy
The general economic conditions of a country whose currency is being traded has a marked impact on the strength and movement of the currency. If the economic conditions are languishing, the currency may also lag in the marketplace, as investors start to lose confidence. Because currencies are traded in pairs, a comparative analysis becomes necessary as between the respective economies of both countries underwriting the currency.
Specific Economic Reports
Various countries regularly issue economic reports reflecting specific aspects of that nation’s economy. Examples of such reports include those that review the retail sales, home building, trade balance and manufacturing data. Depending, in part, on the size and worldwide economic ranking of the particular republic, the economic reports will vary regarding the impact on its currency in the face of other currencies. Naturally, reports from countries like the United Kingdom, United States, Canada and those comprising the European Economic Union tend to have the greatest impact on the market. Reports which emphasize the employment statistics and interest rate changes (e.g. the U.S. Non-farm payroll and FOMC, respectively) generate tremendous interest and activity on the part of traders, causing the market to make drastic movements.
Inflation Rate
When domestic prices in a country go up, the affiliated currency tends to decrease in value internationally. An extreme example to illustrate this would be the nation of Zimbabwe. Suffering from an inflation rate of about.7,000%, this African country has seen its currency go from 57:1 five years ago to now almost 31,000:1 against the U.S. Dollar. This of, course, makes imports more expensive which, in turn, continues the upward thrust of inflation.
Political Outlook
Certain countries, such as those comprising the G8 (Canada, France, Germany, Italy, Japan, Russia, U.K and the USA) generally enjoy political stability. This helps to strengthen their currencies against other countries that do not share such stable governments. If the political future of a country is threatened by disrupting events such as a coup, civil war, international war on its own soil, nationalization of private resources, etc., foreign and some local investors tend to shy away from direct investment as well as investment in the currency and equity markets of that country. When a currency is not traded in large amounts, it is said to have minimal or no liquidity. When the liquidity of a currency is insubstantial, the spread–i.e. the broker’s compensation–tends to be very high, to accommodate for the high risk associated with an illiquid currency.
There is no doubt that the ultimate factor determining the movement of a given currency is the amount of trust the universe of investors have in its ability to withstand all of the factors affecting it. If there is no trust, the value will fall.
Sandy Robinson, J.D., Copyright 2007
