It is very difficult to predict how the market price of a currency will move in relation to another currency. Currency exchange rates are impacted by such as wide host of factors, including psychological ones and the intrinsic herd-mentality of speculative markets. Sometimes a simple rumor is enough to make a currency sink like a stone, at least temporary.
Not only is it difficult to predict how the forex market will react to something, but it is also notoriously difficult to predict how strong that reaction will be, and what any counter-reactions will look like.
Examples of factors that can influence the price of a currency in relation to other currencies
- The overall economic situation of the issuer of the currency.A strong economy will often mean a strong currency as well.
Of course, if the currency becomes very highly valued, this can become problematic for export companies, and a problematic economic situation can arise for certain sectors of the country. At the same time, other sectors can be doing great since they profit from the low-cost of imported goods.
- The commercial balance of the issuer of the currency.A trade-deficiency will normally lead to a weakening of the currency.
- The political situation for the issuer of the currency.Unrest and instability will typically cause a drop in currency value. A stable political situation that is still not a good political situation can translate into a currency that is low value, but stable.
- Targeted speculation by one or several major currency traders. Sometimes even a comparatively small purchase or sale can be sufficient to trigger other traders to act in certain ways.
It is often difficult to pin-point one specific reason for a currency to be weak or strong, or go up or down, since factors such as these tend to be intertwined with each other.
The economic situation
Different traders can also have different ideas about what actually constitutes good political and economic situation. There is for instance those who are very focused on Gross Domestic Product (GDP), while others prefer to also look at GDP at purchasing power parity per capita. Other important factors are national debt, retail sales and employment/unemployment/underemployment statistics.
One things that is very likely to cause a dramatic drop in currency value is an issuer that struggles to pay its debts. This will of course make the situation even worse for the issuer, if there are debts that must be paid in foreign currency.
In the list above, the issuer’s commercial balance is mentioned as one of the factors that can impact the market value of a currency. But what is this and how is it measured?
Commercial balance is the net export measured in local currency. If the issuer’s (e.g. a country) exports are of a higher monetary value than the imports, the issuer has a positive commercial balance. If the value of the exports is smaller than the value of the imports, the commercial balance is negative. A negative commercial balance is also known as a trade deficit, and will typically bring the valuation of the currency down.
Example: Country A exports a lot of high-value consumer goods. The countries that import all these products must pay for them using the currency of Country A. Therefore, the importing countries must purchase a lot of Country A currency at the forex market. The more sought after a currency is, the higher the price. The currency of Country A is therefore highly valued.
If Country A had to import a lot of products, that could serve to bring the value of Country A currency down, since Country A would have to exchange a lot of its own currency for foreign currency at the forex market to pay for the imported goods. When Country A wants to sell a lot of its own currency, the availability of Country A currency at the forex market increases, and this impacts the demand-supply balance for Country A currency.
It is important to remember that if the issuer is a country where producing goods for export is very important for the economy, the government might not want to see the currency get any stronger. A strong currency would make the exported products more expensive for foreign buyers, and the products might be out-competed by products produced in a country with a weaker currency. This would mean less revenue from exports, and probably also increased unemployment and underemployment as companies close down due to decreased foreign demand for their products.
To avoid such a scenario, the government might take various actions in an effort to keep the currency from appreciating against other major currencies, and this is important for you to know if you are an FX trader. It should also be noted that a government might like the idea of having a low-valued currency since that can make domestically produced goods more sought after within the country, as imported goods becomes prohibitively expensive to purchase.
Political stability and change
When it comes to the forex market, political change can often have a larger impact than the overall political situation – especially if we are looking at short-term fluctuations in exchange rates. This means that if something suddenly changes for the better for the issuer of a currency, the currency can appreciate markedly, even though the political situation is still very far from being good.
The currency can appreciate in value against the currency of another country where the political situation is actually much better. The traders react to the change. Along the same lines, the valuation of a currency can drop sharply simply because a political situation is going from excellent to just fairly good.
It should also be noted that sometimes a currency will appreciate simply as a reaction to the political situation in other countries. The political situation in Country A can be stable, but the currency is still going up like a rocket since the political situation in Country B, C and D is taking a turn for the worse and traders are rushing to own Country A currency.
Of course, if Country A and Country B are neighbors or in any other way linked closely to each other, we might see the opposite thing happening. Country A is stable, but its currency is dropping in value anyway because traders fear that the political turmoil in Country B will soon impact Country A in a negative way.
One of the reasons why fx traders shun political instability and social unrest is because they fear that investors (e.g. company owners) will pull out of the troublesome country or at the very least avoid making new investments. Such actions can lead to decreased demand for the currency, and traders don’t want to find themselves stuck holding currency that few buyers want.