Factors affecting currency exchange rates. How to make expert analysis of economic trends and political factors
Let’s review the major fundamental factors, which affect currency exchange rates and on which market participants usually focus their attention.
The factors are:
- Goods market — shows the economic state of a country or a region, interaction between demand and supply and productive forces.
- Monetary policy of the Central Banks — determines interest rates and influences on the value of money.
- Labor market — indicates economic growth pace and commercial activity.
- Business activity — shows manufacturing and commercial activity, sales, and demand for goods and services.
- External and geopolitical factors — well-known political risks, spontaneous social risks, natural disasters.
We have indicated fives main factors, based on which a trader can evaluate the state of the market, market sentiments and be aware of the latest events.
Let’s review each of the factors in the context of the latest world events.
Goods market and indicators of economic growth
Goods market reflects consumers’ welfare in the country or in the region (for example, in Eurozone).
Analysis of the goods market shows consumer sentiment, purchasing power and manufacturing activity.
Note that manufacturing activity is strictly correlated with the purchasing power and it is important to review the whole chain of interrelated factors.
For example: according to Russian Service of State Statistics, in Q1 of the fiscal 2016, consumer confidence index in Russia fell to 11-month lows, which means that 17% of people in Russia cut costs for purchasing new clothes, electronics or holidays. At the same time, manufacturers of clothes, electronics and holiday providers have to reduce market supply to avoid overproduction.It enables us to make a reverse analysis. If production of clothing is decreasing, it means that purchasing power is going down.
Positive goods market in the country means growth in GDP and GNP, the increase in purchasing power and labor productivity, and the uptrend in the national currency.
If goods market is negative, GDP and GNP go down, inflation rate accelerates, labor market declines and national currency is in the downtrend.
Assessment of the goods market helps to make an accurate forecast of the long-term trend in the currency pair. This assessment is usually done by the commercial enterprises, hedge funds, traders and investors.
Money market and monetary policy
Monetary policy of Central Banks has strong influence on the currency trend, and should be considered in the analysis of market movement.
The Bank of Japan regulates the yen; the Bank of England regulates the British pound, and so on. At the same time, national currency is an instrument regulating economic relations, as the rise or decline in the value of money affects prospects of various economic sectors.
Monetary policy has a strong impact on the national currency.
Cheap money policy — is a policy of the Central Bank aimed at reducing the price of money. In order to achieve this purpose Central Bank can lower interest and discount rates at which commercial banks borrow money from the Central Bank. This measure leads to the reduction of the purchasing power of the national currency and helps boost growth of business activity in the market. As a rule, monetary policy easing develops bearish trend in the national currency.
Expensive money policy is aimed at reduction of inflation. Central Bank raises interest rate and deposit rate for the commercial banks.
Expensive money policy develops bullish trend in the national currency and bearish trend in the national stock indices.
Due to the increasing purchasing power of one currency against the other currencies, producers and exporters fail to provide competitive prices for their products in the markets.
However, sometimes situation is unpredictable. Recent and unexpected victory of Donald Trump in the US presidential election has triggered the rise in the USD to the 11-month highs due to expectation of changes in the monetary policy. Both, victory of Donald Trump and the effect of this victory on the monetary policy were unpredictable.
Although Donald Trump openly supports cheap money policy, protectionism and the development of the industrial enterprises, the economic part of the electoral program was perceived by economists and investors in different ways. Prospects of the increase in business activity can reduce the value of money, which means acceleration on inflation. Trump victory triggered bullish trend on the December futures for the Fed rate.
Labor market and employment rate
Labour market creates supply and demand for labour, man power. Modern labor markets usually develop on the principle of free competition. This principle is determined and protected by economic and political principles starting from the political order in the country and ending with the the environmental situation in the region.
Positive development in the labor market will trigger “bullish” trend of the national currency.
Negative labor market, high unemployment rate and large number of applications for unemployment benefits will trigger “bearish” trend of the national currency.
Labor market is largely affected by the internal and foreign policy of the country, such as reforms or immigration policy. Remember migration crisis in Europe, which has forced politicians to create new jobs for migrants, although the companies did not need more workers. This fact combined with some other economic problems led to overheating of the labor markets and mass job cuts. For example, in the energy companies - French company Areva made redundant more than 6.000 employees worldwide.
On the other hand, there is an interesting example with Donald Trump, reflecting the opposite policy. New President threatened to deport illegal migrants, which in the short-term, has warmed up labor market, giving opportunity to increase the number of new jobs and industrial activity in general.
Cyclical shares have been growing during the last trading week. Even stocks of the banks and real estate market in Europe has grown on the news, triggering the rise in investor sentiments, profit taking and hedging in financial markets.
Securities market and business activity
Although traders do not like to work with traditional asset classes, it is advisable to analyze stock markets events. Stock market data reflects capitalization and liquidity, which interconnected with the rate of inflation and monetary policy of the Central Bank.
Growing securities market indicates the bullish trend of the national currency, showing that producers of goods and services can borrow funds with high interest rate. In this case, Central Banks have prospects for monetary policy tightening.
In case of weak securities market, Central Banks have to stimulate production activity in the country, reducing the rates at which commercial banks can borrow money from the Central Bank.
You can observe that stock indices fall during the periods, when the national currency goes up against the other competitive currencies. High demand for the national currency leads to the rise in prices of goods and services, undermining consumer activity and competitiveness of companies in the markets.
Political situation and other factors
It is very difficult to cover and take into account all the factors affecting exchange rates, as economic world is vast. However, recent events show an interesting example: the victory of Donald Trump in the US election. Hillary Clinton has lost election despite all the predictions giving way to the representative of the Republican party. However, But markets managed to use the situation to their advantage.
For example, European financial sector, as well as cyclical stocks has grown to six-month highs within few days. It means that the bearish trend in one currency often triggers the bullish trend in the other assets. Weak currency ensures the inflow of investments in traditional asset classes, making the goods cheaper and more competitive.
If we go back to the migration crisis in Europe or, say, referendum on Brexit in the UK, which pushed the pound to 30-year lows, we can observe a cyclic decline in all spheres. Poor state of economy discourages investors to buy government bonds and shares of the companies. Only largest investors can benefit from such events.
Natural disasters shall be also taken into account. We cannot predict them in advance and they have a minor effect compared with the political events and economic processes.
A trader shall consider all the above factors and build his/her strategy taking into account all of them.
Do not forget to consult economic calendar and make long-term forecast for the currency pairs.