In this article, I’ll delve into the ten factors that affect the fundamentals of the forex market so that you keep them in mind when placing your next trade. Let’s get down to it!
Fundamental analysis in the forex market
Whether you trade stocks or forex, you can use the two basic forms of analysis: fundamental and technical analysis.
However, while technical analysis, that is, the methodology that attempts to predict the future direction of an asset using past market data, does not necessarily vary between assets, countries, unlike companies, don’t have a balance sheet to calculate the intrinsic value of its currency.
How can fundamental analysis of a currency be carried out to calculate its intrinsic value?
Since fundamental analysis tries to find out the intrinsic value of a financial asset, its application in forex implies observing the economic conditions that affect the valuation of a country’s currency.
10 factors that play an essential role in the movement of a currency
Several factors determine exchange rates of a currency and all are related to the trading relationship between two countries *.
*Remember that exchange rates are relative and not absolute since their value depends on the relationship between the currencies of two countries
The inflation rate of a country can have a significant impact on the value of its currency and, consequently, on the exchange rates of other nations.
Generally, a country with an inflation rate lower than that of its trading partners’ will lead to the appreciation of its currency thanks to the increase in purchasing power that this entails and vice versa.
For example, if the inflation rate in the eurozone were relatively lower than in the United States, exports in the former would become more competitive than in the latter, which would increase the demand for euros to buy goods in euro countries. The higher the demand for a currency the greater its appreciation.
2. Interest Rates
Interest rates, inflation and exchange rates are highly correlated. By manipulating their interest rates, central banks influence inflation, as well as the value of their currency.
High-interest rates offer higher returns to investors compared to other countries which will increase in the value of the high-yield currency.
However, the impact of high-interest rates is mitigated if the country’s inflation is much higher than in others, or if additional factors lead to the depreciation of the currency.
3. Current-Account Deficits
The current account is a section within the balance of payments that records a nation’s transactions with the rest of the world –specifically its net trade in goods and services, its net earnings on cross-border investments, and its net transfer payments– over a defined period of time, such as a year or a quarter.
A current account deficit implies that a country imports more goods and services than it exports, so it will have to borrow capital from external sources to compensate for its lack of capital, causing its currency to depreciate in relation to its trading partners.
Excessive demand for a foreign currency will cause the depreciation of the local currency until domestic goods and services are sufficiently cheap and competitive to stimulate the demand for local products, and therefore, its currency.
4. Public Debt
Countries often borrow capital to finance projects in the public sector to stimulate their economy. However, nations with large public deficits are less attractive to foreign investors, since higher debt leads to higher inflation which results in the depreciation of their currency (printing money by central banks generates inflation as discussed above).
Besides, a massive debt can cause serious concern in foreign investors, as they may put into question the solvency of the country and sell their bonds with the subsequent “depreciation spiral” of the currency. (The financial crisis in Iceland in 2008 caused a rapid fall in the value of the Icelandic krona).
For this reason, the rating of the country’s debt by rating agencies (Moody’s or Standard & Poor’s) is a determining factor in the exchange rate of a currency.
5. Terms of Trade
The terms of trade measure the relative evolution of the prices of exports and imports of a country, expressing the evolution of the price of the products exported from the countries.
If the price of a country’s exports increases more than that of its imports, its terms of trade will have improved compared to that of its trading partners.
This translates into an increase in export earnings by providing greater demand for the currency of the country and the following increase in value.
6. Political Stability
Foreign investors look for stable countries to invest their capital. An event that causes instability in a country can lead to the loss of confidence of its investors causing a capital flight with severe consequences for the currency.
7. Speculation: market sentiment
Movements in the exchange rate are not always determined by economic fundamentals and are often driven by market sentiment.
Speculators will buy a currency that they believe will increase in value shortly, increasing its demand and, consequently, its value.
8. Relative strength of other currencies
In 2010 and 2011, both the Japanese yen and the Swiss franc acted as safe havens, as markets were concerned about the health of the global economy, especially the USA and Europe. This meant that, although interest rates were low in Japan and Switzerland, their currencies appreciated due to growing demand.
9. Government intervention
Some governments try to influence the value of their currency. China, for example, has done everything in its hand to devalue the yuan with respect to the United States to favour its exports. In order to achieve this, they buy assets denominated in US dollars, which increases the value of the USD against the Chinese yuan.
10. Economic growth/recession
A recession can cause a depreciation in the exchange rate, since during recessions interest rates generally fall.
The case on the pound sterling from 2007 to January 2009
During this period, the value of the pound fell by more than 20% because:
- The United Kingdom had a large current account deficit in 2007.
- The Bank of England reduced interest rates down to 0.5% in 2008.
- The recession hit the UK economy hard, which caused markets to expect interest rates in the United Kingdom to remain low for a considerable time.
- The Bank of England began its quantitative easing program (increasing the money supply). This raised the prospect of future inflation, making UK bonds less attractive.
A final note
Multiple fundamental factors determine the value of a currency, and that is why successful traders seek to combine fundamental and technical analysis to yield better returns in their trading strategies.