The forex market
Traders make two kinds of analysis before making their market predictions. Technical analysis and Fundemental analysis. The former is based on historical data and charts. The latter on news that affect these markets like political developments, economic figures and other relevant news that affect the forex market. In this article we are going to look in more detail at the latter most important independent variables that affect floating exchange rates. We will see how these are mainly determined by supply and demand, which reflect trade and other international payments, but also by short term shocks and change of circumstances on different countries and hence the currencies they use.
Underneath the forces of supply and demand, in the shorter term, the impact on exchange rates is produced by the flows of the capitals which are continuously shifting around the world in search of the best expected invested returns. Understanding money flows will help us position our capital correctly on the markets.
What determines Exchange rates? Theories
There is no one net explanation on what determines exchanges rates. However, broadly speaking there are two main theories: The Purchasing Power Parity (PPP) and Asset Markets or portfolio balance.
The PPP theory states that in the long term, the rates move to keep international purchasing power in line (parity). For instance, if Inflation in the UK is 6% and inflation in the EU is 4%, following this theory, the GBP will depreciate 2% against the euro. As these currencies are trading by means of the floating exchange model, the adjustment will occur automatically, without the need of any policy intervention.
The Portfolio approach suggests that exchanges rates move to balance total returns (interest plus expected exchange-rate movements). If, for example EUR deposits pay 5% and GBP deposits 3%, investors will buy EUR for higher return, pushing the EUR up.
The portfolio theory could by applied and becomes more meaningful in the short term, where it can be used to explain exchange rates movements, while in the long run exchange rates are determined by PPP.
The correlation between exchange rates and economic variables is quite complex. Although floating rates are mainly determined exogenously, we ca identify the role of the central banks as the most significant causal variable on this market.
Central banks define the monetary policy of a country’s currency. The interest rates decided by central banks are probably the most significant variables in shaping the currency exchange rates. Central Banks do also intervene in the market, buying and selling their national currency in order to alter the balance of supply and demand and move the exchange rate (short run impact).
Banks and other Financial Institutions
Banks are some of the largest participants in the foreign exchange market. Banks trade between them in a market called Inter-bank market. They make currency transactions through an electronic brokering system based on credit. Bigger banks have bigger credit relationships between each other, therefore they can usually get better pricing than smaller banks.
Hedgers and Speculators
Hedgers and speculators are the biggest clients in the forex market. Hedge funds offer financial services to businesses which implies large transactions. Hedge Funds secure and (as their name suggests) hedge clients’ portfolios against uncertainty or unfavourable changes in the market. Speculators on the other hand seek to profit from predicting markets movements.
Political and Macroeconomic indicators draw the principal picture of the health of an economy. They shape and influence traders’ decisions to value a currency at any given point. Macroeconomic and political decisions such as monetary policies and elections may impact or change the course of an economy. Traders able to predict this events through the reading of macroeconomic data can anticipate future market movements and profit from it.
A country has its own macroeconomic goals determined by governments and law representatives. The most common goals are:
High and smooth Growth, low unemployment and Inflation. Goals may be incompatible with one another so sometimes targets are to be set.
The major Macroeconomic variables can be classified into three groups:
These three major variables can be achieved via key macroeconomic variables such as the Interest rates, the government budget balance and financing, the International trade balance and productivity.
Let’s look into detail these key factors in order to help you understand how the forex market reacts to the fundamentals.
Unemployment Rate and Employment
Employment and job creation
Employment and job creation are the foremost indicators of consumer spending. Looking for example at the United States, the two most important indicators are the NonFarm PayRoll and the Unemployment rate. These two indicators are released the first Friday of every month by the Bureau of Labour Statistics.
The Nonfarm Payroll data measures the change in the number of people employed during the previous month outside the farming industry. A higher than expected reading tends to be understood as a bullish/positive signal for the USD. Vice-versa, a sharp drop in this indicator indicates a contraction of the economy.
The unemployment rate shows the percentage of the total labour work force that is unemployed and actively seeking employment during the previous month. A higher than expected reading should be taken as negative/bearish for the USD, while a lower than expected reading should be taken as positive/bullish for the USD.
Inflation is defined as “a sustained increase in the general price level of goods and services”. As inflation rises, consequently the purchasing power of a currency falls. One of the Central Bank’s goal (Europe) is to control inflation and avoid deflation, this will maintain the growing smoothly.
In the USA, the FED has three main goals, to keep moderate interest rates, reach maximum employment and price stability. In order to keep the price stable, the FED sets a goal of a steady long-term rate of inflation. In Europe, unlike the FED, the ECB has established to maintain the growth of consumer prices below 2%.
It measures increases and decreases in pricing levels over a period of time. Changes on this indicator are correlated with changes in currency exchange rates. Inflation is more likely to have a significant negative effect. However, a very low rate might be a sign of a weak economy and therefore the exchange rate will also be negatively affected.
In the USA, the index is published by the US Bureau of Labour Statistics while in Europe by the Eurostat. A higher than expected reading should be taken as positive / bullish for the USD (as the common way to fight inflation is raising rates, which may attract foreign investments), while a lower than expected reading should be taken as negative and bearish for the dollar.
Interest rates are the annualized rate of return on a financial investment. This key variable is influenced by changes in output and in monetary policy.
Interest rates are one of the most important drivers of the forex market. The Interest Rate is highly correlated with the inflation rate. The interest rate of a country is set by its respective central bank. It is used as a tool to manage the economy – either by raising the interest rate to curb inflation, or lowering the interest rate to promote growth.
Higher interest rates are normally correlated with strongly growing economies. Investors are more likely to invest in an economy that is growing. In this sense, the demand for local currency is likely to increase leading the value of the national currency to increase in value. A higher interest rate also means greater profitability for the capital kept in bank accounts.
In the USA, the Federal Open Market Committee (FOMC) members vote to decide on where to set the rate. In Europe, there are six members of the European Central Bank (ECB) Executive Board and the 16 governors of the euro area central banks who vote on where to set the rate. Changes are closely followed by traders as short term interest tend to be one of the most significant factors in currency valuation. A higher than expected rate is positive/bullish for the USD, while a lower than expected rate is negative/bearish for the USD.
Other influential variables
One of the principal key factors in the forex market comes from the desirability of holding that nation's currency. This perception is determined from a wide spectre of political and economic factors, such as the political stability and the economic health of that country. If the country is perceived as economically or politically unstable or if there is a suspicion of a sudden devaluation, investors will move away their deposits from the currency they hold.
The current account is the trade balance between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the national current account shows that the country is spending more on foreign trade than it is gaining via exports. Hence, in order to pay for the imbalance in imports, the state needs to buy more foreign currency. The excess of demand for foreign currency decreases the exchange rate of its own currency until the domestic goods and services are low enough for foreigners, while foreign assets are too expensive to generate benefits for national interests. One of the reasons national governments and banks devalue their currency is also to become more competitive in international trade. The process when widespread is referred to as “currency wars”.
Balance of Payments:
The Balance of Payments is the first indicator of market pressures on a currency. It is the balance of the account calculating the total currency flows.
It is a common practice that countries use public debt to finance their public projects. Such activity stimulates the national economy. However, nations with large public deficits and debts are less attractive to foreign investors. A large debt boosts inflation and if inflation is high, the currency will be weaker. Inflation will be maintained by the states in order to pay the debt.
|Gold (rises)||USD (decrease value)||During times of economic turmoil, investors tend to move their deposits in dollars to gold. Unlike other assets, gold tends to maintain its intrinsic value.|
|Gold||AUD/USD||Australia is the third biggest gold producer in the world|
|Gold||NZD/USD||New Zealand is also a big producer|
|Gold||USD/CHF||25% of Switzerland reserves are in gold.|
|Gold||USD/CAD||Canada is 5th largest producer of gold|
|Bond Yields||Local Currency||An economy that offer higher bond yields attracts more investments on its own currency.|
|Oil||Canadian dollar||Canada is a major producer and exporter of oil. The Canadian economy is driven to a significant extent by oil prices. The Canadian dollar increases in value when oil prices rise .|
|Dow||Nikkei||The performance of the U.S. economy is tightly related to Japan’s economy.|