Factors That Affect Forex Exchange Rates

Whether you are going to be using fundamental analysis or not in your trading, you are probably curious about the factors that affect Forex rates. If you are relatively new to trading, this is the subject you may not be well versed in. The economic factors surrounding Forex are many and they are complex, so you might never have perfect understanding of them (plenty of successful traders do not), but the more thorough your understanding is, the more useful knowledge you have at your disposal.

Some of the main factors that affect FX rates include interest, inflation, trade balance, speculation, foreign investment, and central bank intervention. Interest rates and inflation are interlinked concepts. When inflation is high in a country, the central bank of that country may raise the interest rate for borrowing money, which reduces consumer spending in turn. When inflation is low, a central bank may drop interest rate to indirectly encourage consumer spending. Currencies that have higher interest rates offer a more substantial return, so oftentimes Forex investors will buy into them and sell currencies with low interest rates to make profit. Doing this over an extended time period is known as a carry trade.

Balance of trade (a country's imports vs. the same country's exports) may also impact the level of demand for its currency. When a country exports more than it imports, that country has a positive trade balance, and there is more demand for that its currency on the Forex market.

Market speculation by large and small traders may also impact the value of a currency. Traditionally, it had been large investors who really moved the market (usually, big corporations and central banks), though now retail spot Forex traders have more of a measurable impact than they used to. Traders speculate based on many different things including economic reports and news. Similarly, investors often flock to currencies they perceive as "safe." For a long time, that were the US dollar, Swiss franc, and the Japanese yen. When confidence in a currency drops, investors sell that currency off. Both actions can impact the value of the currency.

Finally, changing the interest rates is not the only way in which central banks can intervene with their respective economies and alter the currency value. Central banks may also engage in quantitative easing, which is one of the measures of last resort for resolving economic difficulties if cutting the interest rate fails to reach its goal. This is a way in which central banks can increase the liquidity of a country’s banking system. Too much of quantitative easing, and the country's currency may lose its value, making it a risky measure to employ.

As you can see, there are many different factors that drive prices on the foreign exchange market. It involves a tremendous amount of research to actually trade fundamentals; even among professional economists, there is a great deal of disagreement as to how things really work. Nonetheless, trading by fundamentals does work well for some Forex traders. Whatever you choose to do, do thorough backtests and demo tests before you trade with real money. Never speculate wildly — have a method in place for your decisions.