Thinking about getting into currency trading? There’s more to the foreign exchange market than exchange rates. Understanding how the economies of different countries interplay and affect exchange rates is an important factor in determining if you will be successful in trading currencies. Inflation, interest rates, government debt and political stability all influence how currencies will perform relative to each other.
An exchange rate – the backbone of any currency transaction – is the relative price of one nation’s currency versus another nation’s currency. The rate reacts to a number of different world economic and geopolitical events, and can be quite volatile. Unlike stock exchanges like Nasdaq or the Dow Jones, the interplay of different events can be more pronounced and more difficult to fully grasp.
If the prices of goods and services in a country start to increase, that country is experiencing inflation. While inflation does occur in most countries (some see the dreaded deflation: a decrease in prices), the amount of inflation is the key figure to review. A rapid increase in inflation means or could mean that the supply of money in a particular economy is high, and that the demand for goods and services outreaches supply. For countries with central banks one possible solution to curbing inflation is to raise interest rates. High interest rates could be considered a currency’s return, which can prompt speculators to purchase units of that currency and increase demand.
There are a number of economic indicators that show how healthy a country’s economy is. Labor reports can indicate the growth or contraction of payrolls, the unemployment rate and the wage rate. If the unemployment rate of a country falls its wage rate will increase. This will in turn increase the prices of goods or services (inflation), which we had previously discussed.
One major component of a country’s GDP is its current account.
A country’s current account consists of cash inflows-cash outflows. Types of inflows include money from exports, while outflows include money paid for imports or sent out as foreign aid. The balance of trade – exported good values minus imported good values – is probably the most important factor for a currency trader.
Imagine that the United States and Japan, two long-established trading partners, have to purchase each other’s goods with the respective currencies: the yen for Japan and the dollar for the United States. If the United States spend more money on imported Japanese goods than it received from selling exports, it will not have enough yen to pay for the goods and assets it wants to buy. This means that there is a shortage of yen, which will push up the value of the yen until Japanese exports become more expensive than those from the United States and the yen loses value compared to the dollar.
There is probably nothing more frightening to currency traders than a sudden and unexpected political change, especially if that political change occurs in a country that the trader has units of currency in. The main reason for fear is that turmoil creates uncertainty. Will the new government nationalize industry? Run up a huge deficit? Become protectionist? Cause market turmoil? Uncertainty in a country’s future is directly reflected in exchange rates, since a lack of confidence in a currency makes investing in a currency pair denominated in that currency a risky endeavor. This is one of the main reasons why the U.S. dollar has been such a popular currency: while the stock markets may fluctuate there is little government disruption.