Factors Affecting Currency Trading

Although exchange rates are affected by many factors affecting currency trading, currency prices are a result of supply and demand forces. The world’s currency markets can be viewed as a huge melting pot in a large and ever changing mix of current events; supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly.

No other market encompasses as much of what is going on in the World at any given time as foreign exchange. Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several.

These elements generally fall into three categories: economic factors, political conditions and market psychology.

Economic Factors Affecting Currency Trading

Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government’s central bank influences the supply and “cost” of money, which is
reflected by the level of interest rates).

Economic factors affecting currency trading include the following:

1. Government budget deficits or surpluses. The market usually reacts negatively to widening government budget deficits and positively to narrowing budget deficits. The impact is reflected in the value of a country’s currency.
2. Balance of trade levels and trends. The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country’s currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation’s economy. For example, trade deficits may have a negative impact on a nation’s currency.
3. Inflation levels and trends. Typically, a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power and thus demand for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short term interest rates to combat rising inflation.
4. Economic growth and health. Reports such as gross domestic product (GDP), employment levels, retail sales, capacity utilization and others, detail the levels of a country’s economic growth and health. Generally, the more healthy and robust a country’s economy, the better its currency will perform, and the more demand for it there will be.

Political Factors Affecting Currency Trading

Internal, regional, and international political factors and events can have a profound effect on currency markets. For instance, political upheaval and instability can have a negative impact on a nation’s economy.

The rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive or negative interest in a neighboring country and, in the process, affect its currency.

Market Psychology as Factors Affecting Currency Trading

Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:

1. Flights to quality. Unsettling international events can lead to a flight of quality with investors seeking a safe haven. There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The Swiss Franc has been a traditional safe haven during times
   of political or economic uncertainty.
2. Long-term trends. Currency markets often move in visible long term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends.
3. “Buy the rumour, sell the fact”. This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being “oversold” or “overbought”. To buy the rumour or sell the fact can also be an example of the cognitive bias known as anchoring when investors focus too much on the relevance of outside events to currency prices.
4. Economic numbers. While economic numbers certainly reflect economic policy, some reports and numbers take on a talisman like effect the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. “What to watch” can change over time.
5. Technical trading considerations. As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.

Thank you for reading this lesson about Factors Affecting Currency Trading.