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Home : Currencies

Factors that Drive the Forex Market

In this chapter, we shall study some of the major economic and fundamental factors that impact currencies. The objective is to enable the reader to understand the various facets that impact the Forex market of today.

Tejas Khoday
25 minutes read
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Until now, we have covered the basics of the Forex market. We have spoken about things such as how to read a currency quote, major currencies that are traded around the world, how the currency market operates, currencies that are traded in India, types of participants in the Forex market, and types of instruments that are available for trading in the Forex market. We have also spoken about how the Forex market has evolved from the earliest Barter system of exchange to the currently prevailing Free-floating system.In this chapter, we will talk about and describe some of the major economic and fundamental factors that impact the Forex market.

But before proceeding further, let us talk about a few concepts that are closely linked to each other: inflation (deflation), nominal interest rate, and real interest rate.

 

Inflation

Inflation is the general increase in the price level of goods and services in an economy. So, if the prevailing inflation rate in an economy is 4%, it means the prices of various goods and services are increasing, on average, by 4% each year. Let us take a very simple example. Assume that the price of butter today is ₹100 per 500 grams and that one year down the line, the price of butter has increased to ₹103 per 500 grams. This 3% increase in the price of butter is nothing but inflation. While a moderate increase in the price level of goods and services is generally accepted and in fact benefits a growing economy, what becomes problematic is when there is too much inflation in the economy.

The reason why this is so is because too much inflation erodes the value of money. On an individual level, the spending power of people will come down because they will have to spend more to buy the same quantity of goods and services.Also, the real rate of return on their investments will reduce, as high inflation will eat up a significant portion of their nominal return. On an economy-wide level, high inflation will lower the real growth (GDP) of an economy. It can also lead to more inflation as people might want to spend more today due to fears that goods and services will become expensive in future. This could worsen the problem even more. Hence, too much inflation can pose a problem to the economic stability of a nation.

When the level of inflation in an economy becomes a threat, central banks usually raise their benchmark interest rates. The reason why they do so is to discourage borrowings (by making it more expensive) and promote savings (by making it more attractive), so that the level of money circulating in the economy reduces. As the level of money circulating in the economy reduces, there will be reduction in demand for goods and services, which in turn will help to lower inflation.

Besides monetary policy (which is conducted by the central bank of the nation), fiscal policy (which is conducted the nation’s government) could also be used to control inflation. For instance, the government could reduce its expenditure (such as that on infrastructure projects) or increase its revenue (such as by raising taxes) or a combination of both, to lower demand in an economy and thereby cool inflationary pressures. Such fiscal measures that are used to tackle high inflation are called contractionary fiscal measures.

 

Deflation

The opposite of inflation is deflation. Deflation occurs when the price level of goods and services in an economy is declining. So, if the prevailing inflation rate in an economy is -2%, we have deflation. The figure -2% means the prices of various goods and services are decreasing, on average, by 2% each year. Let us extend the example of butter taken earlier. What if the price of butter decreases from ₹100 per 500 grams today to ₹95 per 500 grams one year down the line? In this case, there is a 5% decrease in the price of butter. This is deflation.

Deflation is a very complex situation to deal with. It usually, but not always, coincides with a recession. In a deflationary environment, as the price level of goods and services is on a decline, there is a tendency for people to reduce their spending, on expectations that prices will be lower in future than it is today. This reduced spending on goods and services causes unemployment to go up as companies start laying people in reaction to shrinking demand and revenues. The rise in unemployment lowers spending even more, thereby aggravating the problem further. This vicious loop can continue for a prolonged period.

To tackle deflation, central banks could cut their policy rates, in order to reduce the cost of borrowing and kick start economic activity. It could also resort to tools such as printing money, in order to increase money supply in the economy and promote spending. Besides, the government can also use fiscal measures to tackle deflationary forces. For instance, the government could lower corporate and personal tax to boost sentiment, or it could increase the level of spending in the economy to boost employment opportunities, or it could do a combination of both. Such fiscal measures that are used to tackle deflation are called expansionary fiscal measures.

 

Nominal interest rate

Simply put, nominal interest rate is the base rate that you see everywhere. For instance, if a bank Fixed Deposit (FD) fetches an interest rate of 5%, this interest rate is nothing but the nominal rate. Other examples include interest on bonds, interest on provident fund, interest on savings account, interest on loan etc. None of these interest rates take into consideration the impact on inflation. For instance, if I invest ₹100 in an FD that fetches me 5% interest in one year, at the end of one year, I would receive ₹105 (100 * 1.05). However, if the prevailing inflation rate in the economy is 3%, then one year down the line, ₹105 is not going to buy me the same quantity of goods and services that it did buy one year ago. As such, because of inflation, the value of ₹105 one year down the line is not the same as it is today. Hence, one must not solely focus on nominal interest rates, but also on real interest rates, which is the next topic of discussion.

 

Real interest rate

Real interest rate is the interest rate that is adjusted for inflation. In other words, real interest rate is nominal interest rate minus inflation rate. Mathematically, real interest rate is expressed as follows:

Real interest rate = {[(1 + nominal interest rate) / (1 + inflation rate)] - 1} * 100

So, if nominal rate were 5% and inflation rate were 3%, real rate would roughly be 2% (5% - 3%). Mathematically speaking however, using the formula given above,

Real rate = {[(1+5%) / (1+3%)] - 1} * 100 = 1.94%

So, if the nominal rate on an investment is 5% and the prevailing inflation rate is 3%, then the real rate of return on that investment would be 1.94% one year from today. When making investments, it is important to consider the real rate of return rather than just focusing on nominal rate of return.

Let us take another example now. What is the real rate of return if nominal rate were 5% and the prevailing inflation rate were 8%? In this case, the real rate of return would be -2.78%. As can be seen, while on paper this looks like a good investment, in reality, it turns out to be a bad investment.

Let us conclude this section with a third example. What is the real rate of return if nominal rate were 5% and the prevailing inflation rate were -3%? In this case, the real rate of return would be 8.25%. As can be seen, deflation increases the real rate of return, benefiting savers at the cost of borrowers.

Let us now turn our attention towards some of the major factors that impact the Forex market. Keep in mind that this list is not exhaustive. There could be various other factors in play that could impact the value of the currency. However, the factors mentioned below are some of the most important factors that influence the currency movements.

 

Interest rate

Arguably, the most important factor that drivesthe movementbetween currency pairs is the interest rate trajectorybetweentwo economies. In fact, it can be said that the Forex market is driven by interest rates more than by anything else. But how does interest rate affect currency movement? It does so primarily by directly impacting the flow of capital between countries. Think about this for a moment. If you are an Indian and want to invest in a different country, say Australia, one thing that you would want to look at is the prevailing interest rate in Australia and its trajectory. Why? Because interest rates have a direct bearing on various instruments wherein money can be invested. For instance, the coupon on bonds is directly influenced by the level of interest rates in an economy, stock prices are influenced by the level of interest rates in an economy, real estate prices are influenced by the level of interest rates in an economy, and so forth.

If the interest rates in an economy are going up and are expected to continue doing so in future, it makes investments in certain instruments such as fixed income securities more lucrative. In the developed economies such as the US, Europe, and Japan, investments into fixed income securities occupy a bulk of foreign investment. As such, if interest rates in these economies are going up, fixed income instruments become more lucrative because the coupon rates on these instruments also go up. This in turn leads to more foreign inflows, increasing demand for the currency of the nation whose interest rate is going up. This increased demand for the currency leads to an appreciation in its value vis-à-vis the other currencies. The opposite is also true in case interest rates head lower. As interest rates decline, it not only reduces demand for fixed income securities but can also trigger outflow of money from the country, causing the currency of that country to depreciate vis-à-vis the other currencies.

Having said that, in a country such as India, which is a developing economy, a significant portion of foreign money goes into the equity market as well. While bonds benefit because of higher interest rates (as the coupon rate goes up), equities are negatively impacted by higher rates. This is primarily because of two reasons. One is that as interest rates go up, so does the cost of borrowing for corporates, which eats up into their profits. The other is that higher interest rates make bonds attractive, causing some of the capital to shift from equities to bonds. Because of this, rising interest rate in India does not have as much of a positive impact on the Rupee as it does on currencies of the developed economies. The opposite is equally true when interest rates are heading south.

 

Interest rate differential

An important thing to always keep in mind is that currencies are relative. For instance, if the dollar is strengthening, it means it is strengthening not in isolation but against other currencies. Now, we will talk about how interest rate differential between two nations impact currency movements.

Interest rate differential is the difference between the interest rates of two nations. For instance, if benchmark interest rate in the US is 2.5% and that in India is 6.5%, then the interest rate differential between the two nations is 4.0%. If this interest rate differential widens or is expected to widen, from say 4.0% to 4.5%, other things constant, the Dollar would depreciate against the Rupee. Why? Because Indian assets would become more attractive than US assets (because of the relatively higher rate in India). Similarly, if the interest rate differential between the US and India narrows or is expected to narrow, from say 4% to 3%, other things constant, the Dollar wouldappreciate against the Rupee, because US assets wouldnow become more attractive than Indian assets. In other words, widening interest rate differential usually benefits the high-yielding currency (i.e. the currency that has a higher interest rate); while narrowing interest rate differential usually benefits the low-yielding currency (i.e. the currency that has a lower interest rate).

The Forex market is heavily impacted by expectation of future interest rate differential between two nations. This is because the market is always forward looking. The present interest rate differential is already discounted and reflected in the price. What matters more is what could happen in future.Hence, one must keep a close watch on events such as economic data between nations, comments from central bank and government officials surrounding the nation’s monetary and fiscal policy, the outcome of periodic monetary policy meetings etc. in order to gauge how the interest rate differential between two nations could move in future.

One could also monitor the spread between the government bond yieldshaving the same tenure of two nations, to gauge the direction in which interest rates between these two nations could be headed. For instance, if the 2-year US treasury is yielding 1.5% and the 2-year Indian G-Sec is yielding 5.9%, the current spread between them is 4.4%. If this widens going ahead, it is supportive of the Rupee; while if it narrows, it is supportive of the Dollar.

 

Central bank monetary policy

Earlier, we said that interest rate is the most important factor that influences the trend of a currency. And the institution that most impacts the trajectory of interest rate is the central bank of a nation. Using its monetary policy tools, a central bank can adjust the level of interest rate and money supply in the economy based on the incoming set of economic data and economic developments, to achieve its mandate of maintaining monetary and financial stability. Most of the central banks around the world are usually entrusted with maintaining one or bothof: stable prices and maximum employment.

If the incoming set of data suggests that the economy is growing too fast and that inflation is becoming a threat, it could respond by adopting a contractionary monetary policy. A contractionary policy is a policy wherein a central bank raises its key policy rates to tighten the money supply in the economy in order reduce lending and promote savings. The objective of doing so is to lower aggregate demand in the economy and thereby rein in inflationary pressures. Besides raising interest rates, a central bank could also raise its reserve requirement ratio (i.e. the minimum amount of reserves commercial banks must always maintain with the central bank). Doing so reduces the disposable amount of funds banks could give as loans, thereby reducing the amount of money in circulation.

The opposite of a contractionary monetary policy is an expansionary monetary policy. This type of monetary policy is employed by a central bank when economic conditions in an economy are slowing and unemployment is rising. It can also be employed during times when deflationary forces are mounting. Under an expansionary policy, a central bank cuts interest rate to reduce the cost of borrowing, in order to boost lending and promote spending. To objective is to kick start the level of economic activity in a nation and increase employment by trying to boost the level of aggregate demand in the economy. Besides cutting interest rates, a central bank could also lower the reserve requirement ratios or use unconventional tools such as quantitative easing (which is printing money to increase the money base in the economy).

In order to analyse currencies, one must keep a close watch on the policy actions of central banks. This includes the periodic monetary policy meetings as well as occasional speeches of key central bank officials. Most central bank officials give subtle hints about their future monetary stances. Also, post the conclusion of a policy meet, a central bank releases its policy statement, which talks about the present economic conditions while also providing clues about what could lie ahead. These subtle clues are closely scrutinised to gauge the path of the next monetary policy meeting.

The outcome of a policy meet can be divided into three segments: hawkish, dovish, or neutral. A hawkish outcome is when a central bank is optimistic about the economic outlook and potentially signals at a contractionary policy in future. A dovish outcome is when a central bank is pessimistic about the economic outlook and potentially signals at an expansionary policy in future. A neutral outcome is when the policy is neither hawkish nor dovish. If comments from central bank officials or the tone of the monetary policy statement is construed as hawkish, the home currency is likely to respond positively and strengthen in the days ahead. On the other hand, if it is construed as dovish, the home currency is likely to respond negatively and weaken in the days ahead. For instance, if the monetary policy of the Reserve Bank of India (RBI) turns out to be more hawkish than expected, the Rupee is likely to strengthen against its counterparts, such as the Dollar.

 

Fiscal policy of the government

Fiscal policy is a policy wherein the government manages the level of its spending and revenue to influence various aspects of the economy such as the growth level, the level of employment, and the inflation rate.If the economy heats up too much because of which inflation becomes a threat, the government could increase the tax rate or reduce public spending or do a combination of both, to cool down the economy. On the other hand, if the economy has slowed down too muchand if unemployment is on the rise, the government could decrease the tax rate or increase public spending or do a combination of both, to get the level of economic activity kickstarted again.

If the government’s revenue (collection from tax and from other sources) falls short of its spending (public expenditure), a fiscal deficit occurs. In order to bridge this shortfall, the government borrows money by issues debt (usually treasury bills or bonds). Today, a lot of countries run fiscal deficit. While a manageable level of fiscal deficit is widely accepted, what becomes problematic is when the deficit starts mountingbeyond a manageable, accepted limit. This is because it increases the total debt burden of the government, which could impact the nation’s credit rating and subsequently erode the confidence of international investors towards the outlook of that nation. This can cause the currency of that country to depreciate vis-à-vis other currencies.

On the other hand, if the government’s revenue exceeds its spending, a fiscal surplus occurs. As the revenue exceeds spending, the government saves money.It can thenuse this money for economic expansion or for paying off its existing debt or saving it for future exigencies. As the budget surplus improves the financial position of the government, it could have a favourable impact on the nation’s outlook and in turn increase the inflow of foreign money into the country. This in turn can cause the currency of that country to appreciate vis-à-vis other currencies.

Budget deficit/surplus is expressed as a percentage of the nation’s GDP.

 

Economic data

Economic data can have a strong influence on the trends of currencies. Hence, it is extremely important to keep a track of various data that are periodically released by India as well as by some of the major nations around the world, most notably those belonging to the G20 nations. The reason why economic data are so important is that they directly influence the monetary policy of a country. Sometimes, they also have an impact on the government’s fiscal policy.

If the incoming set of data releases from a nation are coming out stronger (as compared to their previous readings), it suggests that economic conditions in the nation are strengthening. This in turn can lead to expectations of a hawkish monetary policy. Furthermore, strengthening economic conditions usually coincide with foreign money coming into the nation, as investors prefer to move their capital from weakening economies to strengthening economies. All these factors combined can cause the currency of the country to strengthen vis-à-vis the other currencies. On the other hand, if the incoming set of data releases from a nation are coming out weaker, it suggests that economic conditions in the nation are deteriorating. This in turn can lead to expectations of a dovish monetary policy. Furthermore, weakening economic conditions usually coincide with foreign money getting out of the nation. All these factors combined can cause the currency of the country to weaken vis-à-vis the other currencies.

As such, one must get into the habit of keeping a track of some of the key economic data that come out from some of the key nations around the world. Also, one must track the broad trend of economic data in general, rather than focusing on just one reading. Why? Because a series of data points rather than just one data point influences the trajectory of monetary policy and/or the foreign money coming into or going out of the economy. For instance, a series of retail sales figures coming out stronger sends a more robust signal than just one retail sales figure coming out stronger over the last few. Hence, get into the habit of not just focusing on a single set of economic number, but on the broader trends of the economic data as well.

In the next chapter, we will focus more on the various economic data and how to interpret each one of them. For now, just keep in mind that if the incoming data indicate at strengthening economic conditions, it is positive for the currency. On the other hand, if the incoming data indicate at weakening economic conditions, it is negative for the currency.

 

Foreign flows into and out of an economy

Foreign money is always in search of higher yields. This is especially true in case of the developed economies. Because of the low interest rates prevalent among these economies, investors from these economies invest in countries havinghigh interest rates (remember the concept of interest rate differential? The wider the interest rate differential between two nations, the higher will be the appeal to invest in nations that have a higher interest rate). For instance, an investor from Japan, where interest rates are close to zero, might want to invest in an emerging economy such as India, where interest rates are much attractive. However, the investment decisions of foreigners, to a great extent, are dependent not just on interest rates but on various other factors too, such as the political situation, the prevailing health of the economy, the monetary and fiscal policy of the economy, etc.

Foreign money flows into and out of an economy based on the outlook for that economy. The stronger the outlook, the stronger would be the inflow into that nation. As the inflow into the nation increases, so does the demand for the currency of that nation (remember, to invest money in a different country, one must buy the currency of that country before investing). And as the demand for the currency increases, so does its value relative to other currencies. On the other hand, the weaker the outlook for an economy, the weaker would be the inflow into that economy. Furthermore, existing foreign investors might also withdraw their invested money from that nation. As the inflow into the nation dries down and outflow increases, the currency of that nation tends to depreciate against other currencies.

Sometimes, currencies themselves can play a crucial role in determining their own trajectory. For instance, let us assume that an American investor wants to invest $100,000 in the Indian market. Let us also assume that the USD/INR exchange rate at present is 70. So, by selling $100,000, the investor would receive₹70,00,000. Let us now assume that the investor buys 1,000 shares of Company A at ₹4,000 per share; 2,500 shares of Company B at ₹800 per share; and 2,000 shares of Company C at ₹500 per share. In a year’s time, let us assume that the share price of A increased to ₹4,400; the share price of B increased to ₹864; and the share price of C increased to ₹525. Combined, the American investor’s investment would now be worth ₹76,10,000. This would represent an appreciation of 8.7% (over the capital of ₹70,00,000). However, let us also assume that the USD/INR exchange rate now stands at 80. If the investor repatriates his or her capital, by selling ₹76,10,000 at the prevailing exchange rate of 80, the investor would receive $95,125. So, although in INR terms, the investor has gained 8.7%, when converted back to USD terms, the investor has incurred a loss of 4.9%.

As can be seen from the above example, big swings in currencies can have a strong impact on the value of the foreign investor’s portfolio. Hence, in case the currency of a nation where foreign investors have put their money depreciates too much, they may decide to pull out of that country, which could put additional selling pressure on the currency of that country.

 

Political and Geopolitical developments

Political and geopolitical developments can have a strong impact on the trends of currencies. This is because such developments can strongly influence the quantum of capital flows intoa nation. Investors would want to deploy their money in countries that are politically stable, have business-friendly policies, and have a good standing with other nations around the world. Inflows into the country tend to increase when such conditions are present. And as the inflows increase, so does the demand for the currency of that nation, causing its value to appreciate.

Meanwhile, investors tend to avoid deploying their money into nations where there is political unrest or uncertainty, the government policies towards businesses are not so favourable, and the nation is involved in some sort of conflict with other nations around the world. The presence of any of these conditions could not only prevent new investors from investing in that country, but it could also trigger outflow of capital from the existing set of investors. As the fresh inflows dry out and existing investors start moving their capital out of the country, the value of the currency of that nation deceases.

 

Prevailing risk sentiment around the world

This factor impacts not just one currency, but all the currencies in general. But what is risk sentiment? Put it simply, risk sentiment reflects the behaviour or the mood of investors who are a part of the financial market. This behaviour or mood is influenced by various factors, such as the prevailing news, economic data, political and geopolitical developments, etc. Broadly speaking, risk sentiment can be classified into two groups: Risk on and Risk off.

Risk on is a situation wherein investors, in general, are optimistic aboutthe developments that are taking place around the world. This could be because of any kind of positive developments, such as strong set of economic data coming out from key nations, favourable outcome to a nation’s election result, positive news coming out from around the globe, etc.In a risk on environment, demand for riskier assets, such as equities, commodities, high-yielding corporate bonds etc., increases; while that for safe-haven assets, such as government bonds, gold etc., decreases. Among currencies too, during a risk on environment, demand for high-yielding currencies goes up, while that for low-yielding currencies goes down. For instance, in a risk on environment, investors could use low-yielding currencies, such as JPY and CHF, as funding currencies to invest in countries that have higher interest rates, such as in emerging market economies. This in turn is likely to cause low-yielding currencies to depreciate vis-à-vis high-yielding currencies.

Meanwhile, risk off is a situation wherein investors, in general, are pessimistic about the global developments. In a risk off environment, safety precedes returns. During such times, investors will reduce their exposure in riskier assets and park their funds in safer assets. As such, during a risk off environment, demand for asset classes such as equities and commodities would decline, while that for safer assets such as government securities and gold would shoot up. Among currencies too, as capital moves out of high-yielding, riskier nations and into low-yielding, safer nations, high-yielding currencies tend to depreciate, while low-yielding currencies tend to appreciate.

As such, one must monitor the risk sentiment prevailing around the globe to analyse its impact on currencies.

 

Movement among other asset classes

Currencies can also be influenced by movements among other asset classes. This is especially true in case of commodities. The price of commodities can strongly influence the FX trends of major commodity exporting and importing countries. A rally in the price of commodities can lead to an appreciation among the currencies of commodity-exporting countries, such as Australia, Canada, Brazil, Russia, Saudi Arabia etc. Meanwhile, the currency of countries that rely heavily on importing commodities, such as India, would be negatively impacted by a rise in the prices of commodities. On the other hand, a decline in the price of commodities would have the opposite impact. Currencies of nations that are major commodity exporters would be negatively impacted, while those of nations that are major commodity importers would be positively impacted.

Besides, currencies can also be impacted by movements among bonds and equities. For instance, if American investors are bullish on the outlook of Indian bonds and equities and as such wants to buy them in the Indian market, they will first have to exchange US dollars for Indian rupees. This causes the Rupee to appreciate against the Dollar. The more optimistic the foreign investors are on the outlook of a particular nation, the stronger will be the demand for the currency of that nation. This will cause its value to go up. Hence, when analysing the trends of the Forex market, one must keep a close watch on the actions taking place in other markets as well, especially in the bond, equity, and the commodity market.

 

Technical factors

Lastly, the short-term trends of currencies can also be influenced by technical factors. Given that a great deal of trading in the Forex market takes place on a short-term to medium-term basis and given the increasing usage of algorithmic trading in the Forex market, charts and price patterns can strongly impact the intraday and short-term trends of currencies. This is especially true in case of the highly-liquid, G7 and G10 currencies. Hence, do not be surprised if you see the price moving quickly in the direction of a breakout, once it breaks out of a price pattern, or important supports and resistances, or fibonacci levels, or moving averages etc. To understand and gain a deeper insight about technical analysis, we strongly urge you to refer to our Technical Analysis section.

An efficient strategy of trading the Forex market is to use a combination of fundamental and technical analysis. By analysingthe fundamentals, such as the ones described above, one would be in a better position to understand about the broader direction of a currency. He or she can then use technical analysis to time the trades better and to identify appropriate entry and exit points. For instance, if the fundamentals suggest that the Dollar is likely to weaken against the Rupee in the short-term, one can use technical analysis to identify regions where the trade can be initiated, regions where the trade can be exited, the momentum of the current trend, signs of reversal in trend etc.

Next Chapter

Analysing Economic Data

15 Lessons

In this chapter, we will discuss some of the major economic data that has a strong impact on the global Forex market. We will speak about how to analyse these economic reports in order to gauge their potential impact on currencies. Towards the end, we will also list some of the most important country-wise economic data as well as the key central bank meetings to keep a track of on a periodic basis.

Types of Exchange Rates

5 Lessons

In this chapter, we will discuss about the two types of currency systems that are prevalent today: the fixed exchange rate system and the floating exchange rate system. We will also discuss about currency convertibility and how it can impact currencies. Finally, we will briefly speak about the Rupee in terms of the type of the currency system that it is under and its convertibility.

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