Factors & Price Movement
This lesson will explore the factors or forces behind price movements. Even though there are various factors that affect the currency market, the final price is always a result of supply and demand.
Market players tend to shift their funds depending on the value of a currency.
For Example, if a currency trader expects the British pound to gain in value, he/she will buy the pound to profit from the increase in price.
While the final price of a currency is an equation of supply and demand at that precise moment, the buyer or seller affecting the price is influenced by different elements that are occurring on a day to day basis.
Previously, we explained that if a currency trader thinks that the Pound is going to rise in value he/she will buy it. Consequently, what do you think affects a trader’s thoughts regarding a currency pair? In other words, what drives people to buy or sell a currency?
Interest rates
Interest rates are the root of the Forex market. Interest rates are a modern tool that central banks use to control their economy. When explaining how interest rates affect the economy it is easy to compare our modern economy to a kingdom within a fairy tale story. At the top of the chain sits the central bank (the king of the land). The king of the land has his subjects below him, commercial and investment banks, which interact with the public. If the king of the land rules a new law or changes something within his kingdom, his subjects and followers must obey. It is obviously better for the king to take into consideration his followers best interests; otherwise people will leave his kingdom or rebel.
Similar to a fairy tale story, the central bank controls the economy preventing rapid inflation or deflation by shifting their central interest rates. By increasing/decreasing the central interest rate, commercial banks are obliged to shift their rates, affecting the amount of money in the market.
For example, if the Federal Reserve raises its Fund rate (central rate) from 1% to 2%, banks that the public invest with and borrow from, increase their rates. This situation puts a brake on the economy, while offering an excellent alternative investment other than just spending money (consuming goods). When banks raise their rates an investor can receive a higher yield by investing his/her money, while lenders are forced to take loans with higher interest.
If the Federal Reserve decreases its Fund rate (central rate) from 2% to 1%, banks that the public interact with normally also decrease their rates. This process has the opposite effect on the market, allowing more money to enter the economy.
Interest rates do much more than just slow down or stimulate the economy; they also act a magnet to attract capital to bonds and other interest bearing instruments.
For example if the Fed decides to increase their interest rate, they make certain assets in their economy more attractive than others, which are presenting a lower interest environment.
Investing example:
U.K central bank’s interest rate is at 1%.
Australia’s central bank’s interest rate is at 4%
Let’s say John is the owner of a large firm and he is interested in investing his profits to receive a stable return. When looking at the various interest rates in the market he can see that Australia is offering a much higher return. He also knows that if Australia’s central rate is high, then commercial banks or investing banks will also be offering high rates. From an investing point of view it is worth John’s while to invest his firm’s money in Australian assets.
One has to remember that John can only invest in Australia by purchasing Australian Dollars, consequentially increasing the value of the currency due to the additional demand.
When investors evaluate interest rates or interest rate differentials, their positions are based on interest rate expectations, rather than the current rates in the markets. (Further information is explained in the PDF format)
Interest rate differentials- the difference between two interest rates of two different currencies.
Economic growth
Economic growth - The stronger the economy, the better its currency will perform. During a stable market, the economy will expand at a steady pace. New companies and services will open contributing to the Gross Domestic Product, providing new jobs in the market. Economic growth is a major factor when analyzing a currencies' strength as strong growth will often lead to excessive inflation, forcing the central bank to shit its rates. During a slow patch (an economy that is contracting), the central bank will decrease its central rate to try to stimulate the economy.
Inflation levels
Inflation is often classed by central banks as the number one threat on the economy. Over the years inflation has increased and decreased as central banks try to control a stable inflation environment. Today most central banks release their inflation targets allowing the public to know their yearly inflation objective. Inflation can be defined in a few ways:
1) A steady rise in prices over a period of time
2) The rate at which prices are rising and purchasing power is falling
While there are numerous indicators that can measure inflation, a common one is the CPI (Consumer Price Index). The CPI is an averaged calculated index that tracks the prices of numerous goods that are normal consumed by each household. By tracking these products the central bank can assess the cost of living and adjust its central rates accordingly.
If a central bank sees that CPI levels are increasing then they might be subjected to increasing their central rate, increasing the value of their currency.
Unemployment Rate
Determines the percentage of total work force that is unemployed and actively seeking employment. This result is normally published once a month and gives traders an indication as to the strength of the economy. A downward trend has a positive effect on the nation's currency as working people tend to spend more money, increasing prices of products in the economy, eventually leading to higher interest rates.
Political conditions
Political events in a country, for instance elections, can have an enormous effect on the country’s currency. If traders and investors alike believe that an elected president will have a good effect on the country, stimulating economic prosperity, then global investors will often find assets within that country attractive.
As mentioned during previous explanations, an investor wanting to invest in a country has to convert his money to the country’s currency before doing so, increasing the demand and value.
Mergers and acquisitions
Mergers and acquisitions are terms used when two companies combine their businesses together, forming a new company. Merges are often done through the conversion of large amounts of money as one company will purchase another or come to some type of agreement that involves asset reallocation. Mergers and acquisitions are often done by companies from different countries and involve currency transactions of buying or selling of various currencies.
Apart from the factors described in this lesson, there are additional factors that affect the currency market on a day to day basis. Some of those factors are more obvious, released and mentioned in the headlines, while others are not as conspicuous. In order to help first time traders, our website contains all the major data needed to understand this field. By taking a glance at the economic calendar once a week, a trader can prepare her/his trades accordingly, by knowing what results could affect her/his trade.
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