Fundamental factors, affecting foreign exchange rates: discount rate, macroeconomic indicators, statistics and impact factors psychological factors
Forex is the profit made from exchange rate swings. Traders need to analyze macro and microeconomic statistics, news and psychological factors that affect the currency pair quotes. You will learn from this article about major fundamental factors, affecting currency exchange rates, how to analyze them, how the market responds to different kinds of news and you will also learn how George Soros was opposing the Bank of England.
Factors that affect foreign exchange rates
This article will be first of all interesting for traders who are just beginning their career in Forex and want to in more detail understand the fundamental factors, affecting exchange rates of currencies. I believe that advanced traders are already familiar with this information, but the article may be interesting for professionals as well.
Foreign exchange rates: principle of Forex pricing, fundamental and psychological factors.
Forex currency trading is pure speculation, since no additional product is created by means of buying and selling currencies. Therefore, if someone gains on the growth of a currency price, then someone loses money. There is a general market factor, when the total capitalization of the market declines, that is, all currencies are getting cheaper at the same time. But this only suggests that some other asset grows in price.
For example, if the US dollar to the euro rate is 1:1, the exchange rate changes to 1:2 (you can buy already 2 euros for one dollar), it means the euro is getting cheaper and the US dollar is getting stronger. If the USD/EUR exchange rate remains 1:1 but you could buy 10 grams of gold for 1 dollar previously, and no you can buy only 5 grams, it means that both currencies getting cheaper in relation to gold. Or gold is growing more expensive.
The price of a currency is a relative concept, since it is always expressed in something. That is why the US dollar was taken as a basis. The price other currencies is defined in relation to the US dollar.
If you need to express the value of, for example, the British pound in Japanese yens, then you use a cross rate, where the value of one currency to another is express by the ratio of their exchange rate to a third currency. Now, more about what still affects the value of a particular currency.
Foreign exchange rate may be:
- Fixed. It is set by a central bank manually and is fixed value at a particular period of time.
- Floating. It is formed based on the market factors (offer/demand). Central banks influence the market indirectly, acting, for example, as a counterparty for buying or selling a currency.
A vivid example is the Swiss franc. When the Swiss National Bank announced that it would no longer hold the Swiss franc at a fixed exchange rate with the euro in January, 2015, the franc soared in relation to other currencies, distressing those who bet on the US dollar in the pair.
Macroeconomic fundamental factors
In each country, the central bank is responsible for the national currency’s exchange rate. It has all the means to conduct the state monetary policy. The central bank’s task is to stick to an appropriate course that will be beneficial for all and will support the economic development. For example:
- Devaluing the euro to the US dollar is beneficial for European exporters. They sell their products for the dollars and buy the raw materials and labor in Europe for euros.
- The euro strengthening (or the USD weakening) is beneficial for importers.
Simply put, central banks try by every means to retain the balance, but they do not always succeed. Instruments of central banks:
1. Excessive liquidity and forex interventions. The entire amount of money in the country is called the money supply. The price for a product indirectly depends on the money supply. If the Central Bank conducts an uncontrolled money issuance (it issues more of the national currency), but the production volumes remain the same, the price of the products increases. Since the US dollar or some other national currency can also be called a product, the exchange rate of the national currency also goes down respectively.
The depreciation of the national currency is called inflation. From an economic point of view, moderate inflation contributes to the increase in production; in the U.S. and Europe, the target inflation rate is about 2%. Therefore, in countries where there is high inflation rate or hyperinflation, money supply is withdrawn to stabilize the exchange rate. In countries where deflation is observed, negative deposit rates are introduced.
A remarkable fact: In 1969, a Nobel Prize Winner Milton Friedman offered an idea of “helicopter money”. There had been deflation in Europe and Japan for a long time. Negative deposit rates (when a deposit holder pays for the money protection in a bank) didn’t solve the problem. At that time, there appeared an idea just to give the issued money to housewives. The idea hasn’t been implemented as there are concerns that the deflation won’t be combated because the households will be just saving up. It is remarkable that while some countries like Zimbabwe are trying to manage the hyperinflation, other one suffer from the strong rate of their national currency.
Conclusion: Excessive liquidity and currency intervention weaken the rate of the national currencies in relation to other currencies.
2. Discount rate. Is an indicator of the money value in the country. This is the interest rate charged the central bank to the commercial banks and other financial institutions for the loans, which then send money to lend to the real sector. Low interest rate (cheap borrowing cost) stimulates economic growth. Consequently, the GDP rate increases and increase in consumption positively affects the rate of a national currency. On the other hand, a lower interest rate means that the value of a national currency declines, encouraging investors look for more profitable assets. In the USA, the discount rate has the strongest influence on the US dollar; the higher is the interest rate, the higher goes USD price.
3. Balance of Payments. The balance of exports and imports directly affects the exchange rate. If a country imports much more than exports, it means that to buy goods and services abroad, the country needs to spend more foreign currency, while its inflow is not sufficient. This can be restrained by attracting foreign loans or investors, which will help to establish a balance between exports and imports. Another option to curb imports is to introduce import tariffs that will help develop domestic production, and, therefore, strengthen the exchange rate of the national currency.
4. Foreign-currency and gold reserves. It is another tool, by means of which the central bank can regulate the money supply. FX and Gold reserves are denominated in gold, foreign currency (which is beneficial for the US dollar, since most reserves are nominated in it), bond securities. If the country’s currency is depreciating and the domestic demand for foreign currencies sharply increases, the central bank partially satisfies the demand by selling, for example, dollars to the population, thereby removing the surplus of national money and curbing inflation.
Conclusion: If country’s foreign-currency and gold reserves decrease, it may suggest that the country’s national currency should go down in price soon (if the central bank can’t restrain the inflation growth).
5. Macroeconomic statistics:
- GNP (Gross National Product) and GDP (Gross Domestic Product). The growth of these two indicators positively affects a national currency rate. If GDP rate is rising, it indicates good expansion of the country’s economy, which is interesting for investors. Foreign capitals inflow strengthens the national currency. The indicators are analyzed in dynamics. If the annual GDP growth is slower than in the previous same period, that is a negative indicator.
- Unemployment rate. It is another important indicator of the economic state, and respectively, the currency rate in the country. The lower is the unemployment rate, the stronger is the national currency. In the United States, the report on Non-Farm Payrolls (it measures the number of jobs added or lost in the US economy except for agricultural industry over a certain period) is thought to be one of the most important for the USD value after the discount rate, is estimated along with the average wage.
- Inflation rate. Consumer purchasing power affects the exchange rate. Inflation growth presses it down and so negatively influences a national currency. For economies that strongly depend on foreign economic activity, the inflation rate affects the currency exchange rate especially strongly, therefore, along with inflation, the consumer price index and other similar statistics are also analyzed.
- Balance of budget revenues and expenses. The budget deficit, covered with extra liquidity, increases the inflation rate and leads to a decline of the national currency value.
- National debt. Even if it is not the major, it is also important indicator for emerging markets. The increase in national debt signals weakening of the national currency. The need to manage foreign debt generates excessive demand for foreign currency, thereby increasing its value. Higher default risk discourages investors, reduces foreign capitals inflows, creating its deficit. However, there are exceptions to this rule. For example, the United States.
6. Geopolitics. It includes the following factors:
- Elections. A vivid example is the USD response to Trump’s victory. In autumn, 2016, following the elections, the USD to other currencies hit 9-year highs. It was supported by investors’ expectations of Trump’s policy. And it has been quite met.
- Trade wars. Example: US-China trade war. Here, the situation is not that clear. Hypothetically, trade wars should have a negative influence on the USD rate (investors prefer safer assets). But since the USA has a rather independent economy, the US dollar, on the contrary, grew stronger and the Chinese yuan went down to the lows of 2017. It means that investors believe that the USA will win in the trade war with China and it will support the national economy by means of domestic market.
- International sanctions. Here, an example is Russia where the ruble lost about 15% in the August-September period due to the sanctions of the USA and Europe.
Geopolitical factors also include armed conflicts, all sorts of messages of the countries’ leaders, the establishments of economic alliances and so on. An example is the unexpected result of the referendum in the UK (Brexit) that sent the GBP rate 11% down, to the low of September, 1985.
Conclusion: Traders need to follow the economic calendar and the major world events. But how they will affect the rate of a particular currency pair depends on many individual factors.
The foreign exchange market is also the market of speculative capital, where institutional investors can easily determine the rules of the game. Market-makers, investment banks, large currency holders can affect the rate of a currency pair. Furthermore, the more exotic it is (for example, the pair of the USD to the South African rand), the easier it is to influence its exchange rate. And here, a worth example is the deal recorded in history under the name “Black Wednesday”. In the early 1950s, European states decided to create an organization (a prototype of the European Union), where exchange rates would be tightly controlled with respect to each other. As the basis was taken Germany, which was at that time the most economically developed. Community members agreed that they would maintain the value of their local currencies and the Deutsche Mark with a tolerance range of 6% of the agreed rates. The most effective mechanism for maintaining the exchange rate in the agreed range was the interest rate and the countries’ own foreign currency reserves.
In 1990, Great Britain was challenged by economic troubles: high inflation rate, production decline, low competitiveness in the foreign market. All these problems forced the UK to join The European Exchange Rate Mechanism. Since that moment, the GBP exchange rate was not led by the market conditions, but it was agreed with other community members. Having joined the community at the GBP rate of 2.95 Deutsche marks, the United Kingdom pledged to support it in the range of 2.78 - 3.13 marks.
The UK government hoped that that joining a community will become a kind of “driver” that can indicate the right way to solve economic problems. In the first two years, it was so. Since the government could not arbitrarily control the money supply, the inflation rate decreased, unemployment also went down. But in 1992, the country was challenged by a global recession. The British government could do nothing, because it was bound by the terms of the agreement. It became clear that the British pound was overvalued and the rate was maintained at the permissible minimum solely by the Central Bank’s guarantees.
On September 16, 1992, the media published the speech of the Bundesbank President that some European currencies were about to crash and Germany’s attempt to support will not solve the problem. Investors saw it as a signal. The George Soros Foundation Quantum Fund had been building a huge short position in pounds sterling worth $ 1.5 billion, later raising the short position volume to $ 10 billion.
How it works. Suppose you have a partner who is ready to lend you some amount of British pounds at a small interest rate. You borrow 10 pounds and buy 29.5 Deutsche marks for them. Now it is beneficial for you to let the pound fall in price against the mark, because then, having sold 29.5 marks, you’ll get back not 10, but 12 pounds (conditionally). However, you need to be sure that the exchange rate will go down.
Soros' Quantum Fund had borrowed more than 10 billion of the British pounds, selling it at the same time. His example was immediately followed by hedge funds. By the time the working day began in the UK on September 17, billions of pounds had been sold. The value of the British currency was dramatically falling. The Bank of England lacked the reserves, it just couldn’t buy the offered amount of pounds at the exchange rate, set according to the Exchange Rate Mechanism. To make investors buy the pounds, the UK government raised the bank rate by 5%, there was no result – the market firmly believed in the GBP weakness. Finally, government was forced to withdraw the pound sterling from the European Exchange Rate Mechanism (ERM) after it was unable to keep the pound above its agreed lower limit in the ERM. The pound rate immediately depreciated by 15% to the Deutsche mark, and it was down by 25% to the USD.
This story is a perfect example of how the market psychological conviction affects currency exchange rates. If a few hedge funds dispose more capitals than the central bank’s reserves, they can fundamentally influence foreign exchange rates and the central bank won’t have enough tools to stabilize the rate..
Conclusion: Forex exchange rates are influenced by multiple local and global factors, which a professional trader should monitor and anticipate. You shouldn’t forget about a possible informational manipulation by means of the media. Is it difficult to take all of this into consideration? Yes, it is rather difficult. Therefore, I can only recommend you one thing: gain your trading experience, intuition and diversify your risks. That is what I suggest you do on practice by opening a demo account and following the tips, given in the article. If the article is interesting for you, you have any questions or comments, join the discussion below the article!
P.S. Did you like my article? Share it in social networks: it will be the best “thank you" :)
Ask me questions and comment below. I’ll be glad to answer your questions and give necessary explanations.
- I recommend trying to trade with a reliable broker here. The system allows you to trade by yourself or copy successful traders from all across the globe.
- Telegram channel with high-quality analytics, Forex reviews, training articles, and other useful things for traders https://t.me/liteforex
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.