There are many economic and political forces that can significantly affect the way a currency moves. And typically, they are not fleeting events. They are often massive, long-term, global megatrends that can persist for many months and even years.
Below is a list of some of the key fundamental driving forces behind the long-term trends in the currency market.
Interest Rates
No matter what country a currency is issued in it will have an associated interest rate which, in the short term at least, is largely determined by that country’s central bank. And because interest rates are strongly linked to currency values, changes in interest rates can have an immediate impact on the strength or weakness of a currency.
Interest rate hikes typically have a positive impact on a nation’s currency. Higher rates attract foreign investors, who, in turn bid up the value of a currency. Then, as the currency gains strength, it can attract even more investors seeking the opportunity to make a profit.
Conversely, if a country’s interest rate falls, it will generally put downward pressure on the value of its currency.
Trade Deficits
Typically, a large trade deficit is very negative for a currency’s value.
Not long ago, for example, Brazil was running a trade deficit. That meant Brazilian businesses were importing a lot more than they were exporting. It meant they had to buy huge amounts of goods abroad. And to do so, they had to sell their own currency and buy foreign currencies. The more they sold their currency in exchange for foreign currencies, the more their currency fell in value.
The only world currency that has seem to be immune from a large trade deficit has been the U.S dollar. The primary difference is that the U.S dollar has been the world’s predominant currency for international transactions. And the U.S stock and bond markets have been the primary “home away from home” for international invertors.
And as long as they continue to recycle their dollars back to U.S. investments, America’s day of reckoning will be continually postponed, despite the largest trade deficits in history.
With just about any other country in the world, this would be almost impossible. The United States and the U.S. dollar has been an exceptional case only because of its special status in the world economy.
Economic Growth
When a country’s economy is among the strongest in the world, it tends to attract more investment capital, helping to drive up the value of its currency.
Plus, economic growth typically brings a greater probability of inflation and heightened concern by the government to do something to contain it. How? By raising interest rates. And as we just discussed, higher interest rates are likely to attract more international investors.
Between the strong economy, high interest rates and foreign investments, the country’s currency enjoys greater demand.
Solid economic growth is fundamentally bullish for a country’s currency. Weaker growth or recession are fundamentally bearish for the currency.
Inflation
Higher interest rates aren’t a pure magnet for international money, however. They act through filter- inflation.
For example, if Australian banks pay invertors 6% but inflation rate in Australia is 8%, international investors may say: “What good is 6%yield if it’s being wiped out by the declining purchasing power of the money?” They know that when a currency falls in value domestically, it’s also bound to fall in value internationally.
Meanwhile, if the Euro pays, say 4%, but has an inflation rate of only 1%, the attitude of international investor is likely to be: “The yield may be lower. But the purchasing power of Euro is declining far less. So I’ll accept the lower yield and continue to invest in euros.
Interest rates may impact short-term moves in a currency. But long term, the biggest factor is real rate of interest – the interest rates less the inflation rate.
Political Stability
If you look at fluctuations myopically on a day-to-day basis, it may appear that the foreign exchange market react greatly to spot political disturbances.
But if you look at the market from a broader perspective, you’ll see that it’s the sustainable , long-term economic forces that are the true driver
The one exception: If a country suffered from sustained, chronic political instability.
Market Psychology
An interesting aspect of any market is the way that market psychology can affect it.
In many cases, expectations alone can drive a market up or down.
Greed, fear and other emotions all play a factor how investors react to news, rumours, and expected announcements. And the reaction may – or may not – be in line with reality of the situation.