To trade the forex market with little awareness of the factors that influence the FX market can result in substantial losses. Many of the macroeconomic forces at play can have huge effects on the valuation of a currency.
When looking at forex markets, it's important to remember that a stronger currency makes a country's exports more expensive for other countries, while making imports cheaper. A weaker currency makes exports cheaper and imports more expensive, so foreign exchange rates play a significant part in determining the trading relationship between two countries.
Political instability and economic performance
Political instability and poor economic performance can also influence the value of a currency, such as when there are presidential elections and national recessions. Politically stable countries with robust economic performance will usually be more appealing to foreign investors, so these countries draw investment away from countries characterised by more economic or political risk.
Interest rates
Interest rates, inflation rates and foreign currency rates are all interconnected, and as some rise others can fall. Central banks control the interest rate as a measure to control inflation. If a central bank wants to decrease inflation, it can increase interest rates in a bid to stop spending and lending. This generally increases the value of money in an economy, as there is less, or ‘more expensive’, money available in the economy. On the other hand, when there is more money with less value in an economy, businesses and consumers increase spending and lending through loans and other types of credit. Sellers will then increase prices, causing inflation and a lower-valued currency. These fluctuations in currency value are one of the reasons forex traders may look to trade on interest rate announcements from central banks, like the US Federal Reserve or the Bank of England. This can be done through cross currency swaps, which can help to hedge currency risk on both interest rates and exchange rates.
Inflation rates
Often paired with interest rates, inflation rates can have a major influence on a nation’s foreign exchange rates. Rising inflation rates often have a negative effect on a currency’s value. Conversely, low inflation rates usually cause an appreciation in the value of a currency. When inflation is high, the price of goods and services increases, which can cause the currency to depreciate, as there is less spending.