Factors That Affect Currency Values

To date, there is no exchange rate model that can predict future currency prices with 100% accuracy. In rapidly growing global foreign exchange markets, currency movements become harder to predict as more participants enter the market on a daily basis, bringing with them all their research opinions, emotions, and expectations about where currencies should be headed. Currency movements in the short term can be influenced by publicly available information like the release of the country’s gross domestic product data, the consumer price index, or employment data. The following publicly available information can have immediate impact on currency movements:

  • Local economic data releases and the anticipation of those releases.
  • Economic data releases in foreign countries, especially of major trading partners, and the anticipation of those releases.
  • Central banks, such as the U.S. Federal Reserve or the European Central Bank, raising or lowering interest rates.
  • Central banks making public their thoughts on monetary policy.
  • Expectation of central banks making public their views on local interest rates or monetary policy.
  • Political developments, both globally and in individual countries.
  • Natural disasters and perceptions about how they will impact economies.
  • Changes in commodity prices, particularly oil and gold.

This list is not exhaustive, but these factors would be among the more important catalysts for currency movements.

But there is also information that is not immediately publicly available, such as individual traders in-house strategic analyses on currencies or buy and sell orders that come from customers, which can affect the decision process of market participants. The activities of market participants such as central banks, commercial banks, hedge funds, individual investors, and multinational corporations will be influenced by a mixture of all these factors.

Central banks around the world such as the U.S. Federal Reserve, carry out actions called “monetary policy” to influence the availability and cost of money and credit. The do this to achieve certain national economic goals such as lowering inflation or promoting growth. In 1913 the passage of the U.S. Federal Reserve Act gave the monetary policy power to the Federal Reserve. There are three tools of monetary policy that the Federal Reserve or “Fed” uses:

  1. Open market operations,
  2. The discount rate and
  3. Reserve requirements.

While the FED’s board of Governors makes decisions regarding the discount rate and reserve requirements, the Federal open market committee (FOMC) is responsible for so called open market operations. By using those tools the Fed is able to influence the balances that banks and other depository institutions hold at Federal Reserve banks and are thus able to alter the federal funds rate which is the interest rate which banks lend to each other overnight. A change in the federal funds rate influences a whole host of financial and economic events such as other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and such economic variables such as employment, production output, and prices of various goods and services. The 12 members on the FOMC; including various officials of the Federal Reserve System, hold eight annual meetings where they determine monetary policy after they have reviewed economic and financial conditions and any risks to price stability. The Federal Reserve’s commentary shown above illustrates how such variables as natural disasters, energy prices, political uncertainties and interest rate changes can influence currencies

Currency strategists will look at such factors to forecast price targets for currencies. For example, if a strategist was tasked to predict the expected performance of the Canadian dollar against the U.S. dollar through 2007, he would probably factor in the expected performance of the U.S. dollar over the previous period, as well as expectations of commodity prices that Canada exports such as oil, the direction of interest rates in Canada, and the corresponding rate environment in the U.S. The strategist is also likely to look at expectations of capital and trade flows associated with the Canadian economy, and how Canada’s political landscape is likely to evolve over the period. Thus, in forecasting the expected performance of the “loonie,” the strategist essentially conducts a fundamental analysis of a country underlying economic conditions. To get a feel for these fundamental analyses, here are some common scenarios that can have an impact on currencies:

  1. If a country’s stock market rallies, its currency could strengthen. A stock market rally provides an ideal investment opportunity for individuals regardless of geographic location. As a result, there is a positive correlation between a country’s equity market and its currency. If the stock market is rising, funds will rush in to seize the opportunity. Alternatively, falling stock markets will see investors selling their shares to seek opportunities elsewhere. The correlation between stocks and currencies is strong enough to make currency trader’s watch stock market for cues on performance of currencies.
  2. If oil prices surge to record highs, it can have a negative impact on some currencies. A country’s dependence on oil is very important in determining how its currency will be hit by a spike in oil prices. There will be a greater negative impact on countries that are net oil importers. For example the U S is among the world’s largest net oil importers and thus its economy will be more sensitive to changes in oil prices than many other countries. Countries with alternative fuel sources, and other resources, have the ability to switch from strict oil dependence to other energy sources, which helps to reduce their exposure and sensitivity.
  3. An increase in a country’s unemployment numbers can have a negative impact on its currency. Currency prices reflect the balance of supply and demand for those currencies. A primary factor affecting supply and demand is the overall strength of the economy. The unemployment rate is a strong indicator of a country’s economic strength and therefore a contributor to the underlying shifts in supply and demand for that currency. When unemployment is high, the economy may be weak-and its currency may fall in value.
  4. If a country’s central bank makes a surprise decision to raise rates by more than expected, its currency could rally. Currency traders look at data related to interest rates very closely as interest rate differential are strong indicators of relative currency movements. If a country raises its interest rates, its currency can strengthen in relation to those of other countries because high interest rates help nations attract foreign investment. Economic indicators that have the biggest impact on interest rates are the producer price index, consumer price index, and GDP. Generally, the timing of an interest rate decision is known in advance. They take place after regularly scheduled meetings by the Federal Reserve, ECB, RBI, and other central banks.

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