Forex fundamentals: What makes currencies move?

Forex traders rely on fundamental and technical analysis the same way futures and equity traders do. The use of technical analysis in forex is much the same: price is assumed to reflect the fundamentals. But unlike companies, countries can print money. 

Since fundamental analysis is about looking at the intrinsic value of an investment, its application in forex entails looking at the economic conditions that affect the valuation of a nation’s currency. Here we look at some of the major fundamental factors that play a role in a currency’s movement.

“Currencies move for numerous reasons, ranging from central bank actions to weather disasters,” says Nadia Simmons, forex and oil trading strategist at SunshineProfits.com. “It is important to remember, though, that exchange rates are always expressed in pairs, so you are always measuring pros and cons of two currencies.”

Traders are typically attracted to the foreign exchange (forex) market by the relatively high leverage and 24-hour trading. 

“Of course, high leverage is a double-edged sword: it can help boost traders’ potential profits, but also amplify losses,” says Matt Weller, senior technical analyst at Forex.com.

As long as traders limit their use of leverage, the currency market is particularly well-suited to newer traders, according to Weller. With forex, like futures, it is just as easy to sell as to buy. 

The forex market also is much more liquid than any other market in the world, with more than $5 trillion in daily notional volume, meaning that it is often quicker, easier and cheaper to get into and out of trades than in other markets (see “A bigger playground,” right).

While that size ensures plenty of liquidity, it also is an indication that there are many experienced professional traders who know what to look for.


Interest rates

Forex markets are complex and while there are many fundamental factors that affect their value, ultimately, interest rates and expectations of their direction are key. Interest rates are directly controlled by a country’s (or region’s) central bank. Changes to a country’s key rate (the rate banks charge each other) are a central bank’s most powerful tool and have a significant effect on the currency. “Without a doubt, central bank interest rates are the most important fundamental driver of the forex market,” Weller says. “All other fundamental data can be interpreted through the lens of central bank monetary policy.”

Weller adds that the next most important fundamental factors are inflation and employment because those are the two variables that central bankers focus on when setting monetary policy.

Higher-than-expected inflation readings are typically a positive factor for a developed market currency because rising prices make the central bank more likely to raise interest rates. On the other side of the coin, a weak employment report usually hurts the currency in question because it means the relevant central bank may be forced to cut rates.

Even rumors of changes to an interest rate can produce dramatic moves in the forex market. “You’ll see a lot of activity when there are expectations for interest rates to change,” Simmons says. “When you look at countries that are talking about raising interest rates, everybody watches very closely.”

Central banks often will manage/manipulate their currency by selling it after it rises to an unacceptable level. China has longed pegged its yuan — much to the consternation of the United States—to the value of the U.S. dollar, ensuring the cost of their goods do not rise relative to the dollar, though it has loosened the peg somewhat in recent years. And while the Japanese yen floats, the Japanese central bank periodically has sold the yen when it became too strong relative to other currencies.

Interest rate changes have taken on new meaning in the current economic environment. With much of the West stuck in a zero interest rate environment, forex volatility has dropped dramatically (see “What happened to forex volatility?,” below).

 

While interest rates are a general fundamental factor for currencies, they also provide the impetus for the carry trade where traders buy the currency from a country with a higher interest rate against the currency of a country with lower interest rates. The trade generally works, but can become oversubscribed, leading to massive reversals. Understanding the dynamics of the carry trade is an important fundamental to understand.

Economic growth and trade

While the U.S. Federal Reserve has a dual mandate to stabilize prices and to promote full employment, that is not necessarily the case for other central banks. Interest rates are directly controlled by central banks, but employment and economic growth aren’t necessarily under their control, Weller says.

Employment numbers are a factor for two reasons. First, employment directly affects consumer spending. Second, that consumer spending affects inflation, which plays into central bank decisions on interest rates.

As employment increases, you can expect consumer spending in the country to increase. That’s going to increase your domestic demand and help with employment. If it gets to the point where inflation is a concern, that’s when you’ll see central banks stepping in and raising rates to ease spending. Consequently, employment can have an immediate effect on currencies while potentially providing a forecast of what a central bank may do.

A lot of reports and outlooks factor into a country’s expectations for economic growth. While interest rates and employment numbers can point to those expectations, other reports also provide insight into where a country’s economy is headed.

Gross Domestic Product (GDP) is considered the broadest measure of a country’s economy, and it represents the total market value of all goods and services produced in a country during a given year. However, it is a lagging indicator. Significant revisions to GDP can cause considerable volatility. 

There are a number of reports that show growth expectations. The housing sector is one of the most important to follow, particularly new construction. As houses are built, they’re not actually hitting the market for six months to a year. So new construction is a sign that builders have a positive outlook for growth. 

Simmons follows the statements of central bankers. “The interest rates and employment numbers are of great importance, but it is often the case that the officials indicate their next steps or changes in their overall approach days or weeks before changes are made.”

Markets move on expectations and if you can read between the lines of official repotrs you can gain an advantage over other traders, Simmons says.

While currencies are measured by their relative strength vs. other currencies, they also are measured by their stability. The U.S. dollar has long been the reserve currency of the world. For all its flaws, it is the most stable currency; so when the global credit crisis hit the dollar rallied sharply. The dollar rallied on bad news because it was viewed as a safe haven.

“One of the strongest short-term drivers of the currency market is global risk appetite, or how optimistic or pessimistic traders feel toward the world economy as a whole,” Weller says. 

“For newer traders, this global focus can lead to some surprising outcomes. For instance, when relations between Russia and Ukraine started to deteriorate earlier this year, forex traders predictably sold the Russian ruble and Ukrainian hryvnia to account for the elevated geopolitical risk, but the crisis of confidence also spread to other emerging market currencies, such as the South African rand and Argentine peso, before central banks stepped in to stabilize the markets and restore traders’ confidence,” he says.

Therefore, it’s critical for forex traders to monitor developments from all over the world, as well as other markets like bonds and equities, in order to evaluate the market’s day-to-day appetite for so-called “risk assets.”

About the Author

Yesenia Duran is Managing Editor at Futures magazine. She has covered the financial industry for more than 5 years. She originally joined Futures in 2002 after graduating from Northwestern University where she majored in journalism.