Introduction
Forex markets are known for their high volatility in the financial world. Understanding the internal and external factors that impact forex rates can prepare you for trading in these markets.
Similar to an investment banker, the currency exchange rate plays a crucial role in assessing a country's economic health, alongside factors like interest rates and inflation. Exchange rates are crucial for a country's trade, which is essential for any free market economy.
Governments closely monitor, extensively study, and intervene in exchange rates due to their significance. Exchange rates also have an impact on the real return of an investor's portfolio, even on a smaller scale.
Understanding What Influences Forex Rates and Market Dynamics
Before we look at these market movements, we should explain how exchange rate movements affect a nation's trading relationships with other nations.
When a currency has a higher value, the cost of imports for a country decreases while the cost of exports increases in foreign markets.
When a currency's value is lower, it results in higher costs for a country's imports and lower prices for its exports in international markets.
Exchange rates have a significant impact on a country's balance of trade. When the exchange rate is higher, it tends to have a negative effect on the balance of trade. On the other hand, when the exchange rate is lower, it tends to have a positive effect on the balance of trade.
Let’s now examine some of the key factors that drive market movements in forex exchange rates.
Interest rates
There is a significant connection between inflation, interest rates, and exchange rates.
Governments and central banks have the power to shape exchange rates through interest rate adjustments. One example of this phenomenon is "hot money": when interest rates are higher, foreign investors find the currency more appealing.
Investors quickly and frequently transfer funds from a currency with lower interest rates to a country with higher interest rates, resulting in a rapid return on investment.
Economic recession
Typically, when a country experiences a recession, its currency tends to depreciate. Firstly, it is common for interest rates to decrease during a recession. As a result, there tends to be a movement of funds from the country to nations with higher interest rates.
Imagine Canada experiencing a recession and witnessing a significant outflow of money from the country. In such a scenario, individuals would likely opt to sell their Canadian dollars (CAD) in exchange for other currencies, leading to a decline in the value of the CAD.
It is important to keep in mind that economic and political events in other countries can also affect the movement of a domestic currency during times of recession.
Despite the potential challenges of high inflation and low interest rates, investors often view the United States as a safe haven during a global recession. As a result, its currency (USD) tends to remain stable or even strengthen compared to other currencies.
The stock markets
The stock market and foreign exchange are the most financially traded markets worldwide. When it comes to price predictions, traders frequently seek out correlations between different markets.
Investors tend to feel more optimistic when the domestic stock market rises, which suggests a positive state of the country's economy.
Consequently, foreign investors are showing more interest, leading to a rise in demand for the local domestic currency.
During periods of stock market underperformance, a decrease in confidence prompts investors to withdraw their funds and convert them back into their respective currencies.
Inflation
Inflation refers to the overall increase in prices within an economy, encompassing various goods and services. Typically, we measure this increase in percentages.
For instance, if inflation in the UK were to decrease, the Pound Sterling's purchasing power would rise compared to other currencies. The competitiveness of UK exports will boost the demand for Pound Sterling to buy UK goods.
In December 2022, the European Union's inflation rate stood at 10.4 percent, with Hungary experiencing the highest rate of 25 percent.
Since January 2022, the Hungarian forint has been one of the weakest currencies in Central Europe.
BNP Paribas' research indicates a significant decline in the forint's value against the euro and the dollar, with losses of 11% and 23%, respectively. However, note that inflation is merely one of the contributing factors in this case.
Government and public debt
A country's debt rating can influence its currency exchange rate. Public sector projects often necessitate significant deficit financing, which can have a positive impact on the domestic economy.
Nevertheless, countries with substantial public deficits and government debt are less attractive to foreign investors.
Concerns about a potential debt default can lead investors to sell bonds in that currency, causing a decline in the exchange rate. Inflation can occur when governments print money to repay large debts.
Terms of trade
Economists frequently analyse the Terms of Trade (ToT) or Balance of Trade, also known as the difference between the monetary value of a nation's exports and imports over a specific time period.
If the price of a country's exports increases at a higher rate than its imports, the terms of trade will improve.
When a country's exports are in high demand, it leads to better terms of trade and increased revenue. As a result, there is a greater demand for the country's currency. This will naturally lead to an increase in the currency's value.
Political stability
Political stability in a country can also have an impact on the strength of its currency. Countries with a lower likelihood of political unrest attract foreign investors. Foreign investment has the effect of causing the domestic currency to appreciate.
On the other hand, unforeseen circumstances that result in unstable conditions within a country can cause a decrease in foreign investment, which in turn leads to a decline in the value of the domestic currency.
In 2022, Britain experienced a period of economic and political uncertainty when then Prime Minister Liz Truss resigned after just 49 days in office. Her extensive proposed tax cuts had a detrimental effect on the pound and caused borrowing costs to skyrocket.
Former Chancellor Kwasi Kwarteng's "mini budget" would have required an extraordinary increase in public borrowing of £411 billion over the next five years, potentially plunging Britain into a crisis similar to the 2008 financial crash.
Current account deficits
The current account deficit closely relates to the terms of trade, or trade balance.
In addition to measuring imports and exports of goods and services, the current account also accounts for payments made to foreign investors, payments received from overseas investments, and transfers like remittances and international aid.
For instance, the pound (GBP) might depreciate in value in relation to the Canadian dollar (CAD) if Britain, a frequent trading partner of Canada, experienced a larger current account deficit.
Therefore, nations with smaller current account deficits typically have more robust currencies than those with larger deficits.
Government intervention
Governments and central banks can use the monetary power to stabilise a currency to enact trade policies, increase or decrease money printing, or adjust interest rates.
China, for instance, is hesitant to permit a rise in its currency due to the potential harm to its exports. The goal of the Chinese government's artificial depreciation of the yuan is to increase exports and draw in foreign investment. China's economy is reliant on exports, which it uses to compete with its neighbours, South Korea and Japan.
The People's Bank of China (PBOC), China's central bank, takes in a significant amount of foreign cash due to the country's substantial trade surplus. It purchases foreign exchange from exporters and converts it into local Yuan currency.
Confidence and speculation
A currency's value could decline as a result of political developments or adjustments to commodity prices. Speculators will sell now for a currency they believe will appreciate in value if the Euro declines. Because of this, attitudes in the financial markets have a significant impact on foreign exchange rates.
If the markets become aware of the possibility of an interest rate hike in the Eurozone, for example, we are more likely to see a gain in the value of the Euro.
A US speculator will enter into a contract to purchase euros at a fixed exchange rate in five months if he anticipates that the euro will appreciate during that time. This reduces the risk and losses brought on by fluctuations in exchange rates and is referred to as a forward contract.
Conclusion
By monitoring each of these variables and the current exchange rates, you can make an informed decision when it comes to making foreign exchange payments for your business. It's also possible that you need to send money internationally for private reasons.
The exchange rate of the currency holding the majority of the investments determines the real return on an investment portfolio. It goes without saying that a falling exchange rate reduces the buying power of income and any capital gains from returns.
The exchange rate also impacts other income components like interest rates, inflation, and even capital gains from local stocks. Even the most seasoned economists are frequently baffled by the multitude of intricate elements that determine exchange rates, but investors should still have some idea of how currency values and exchange rates affect the rate of return on their assets.
