Factors Responsible For Currency Exchange Rate Fluctuations

 

Factors That Can Be Responsible For
Currency Exchange Rate Fluctuations

A collage showing paper money bills depicting post pandemic economy, a currency pair chart, and a wall street trader

World Bank/IMF in the 1970s created what is known today as the foreign exchange market.

There were time of fixed exchange rate regime  when currencies were exchanged at fixed rates, until later time when they adopted a flexible exchange rate regime where currencies were allowed to float freely and till this date.

Currency exchange rate is the price at which foreign currencies can be converted to one another in the foreign exchange market at a given period.

There are several factors which can affect currency rate at different time of the day, week, year or over the history of a currency.

The foreign exchange market like a traditional market is majorly determined by Demand and Supply. Any other factor that is responsible for change in demand and supply is can also be considered as factor which accounts for currency exchange rate fluctuations.

Economic Factor

Technical factor

Sentimental Factor.

All these factors have relationship with one another, and understanding of one or more of these factors would help a trader to better picture price dynamic over a given time.

Economic Factors That Can Affect Currency Exchange Rate Fluctuations

There are several Economic Factors, which can also be referred to as; fundamental factors that shape the strength or weakness of the major currencies and will affect you as a forex trader.

Theses Economic Factors can be informs of economic growth and outlook, economic recession. With the economy and outlook held by consumers, businesses, and governments. It’s easy to understand when consumers perceive a strong economy.

Consumers feel happy and safe, and they spend money. Companies willingly take this money and say, “Hey, we’re making money! Wonderful! Now… oh, what do we do with all this money?”

Also companies with more gains spend money. And all this creates some healthy tax revenue for the government which could make them jump on board and also start spending money. Now everybody is spending, and this tends to help a positive effect on the overall economy.

Weak economies, on the other hand, are usually accompanied by consumers who aren’t spending, businesses who aren’t making any money and aren’t spending, so the government is the only one still spending. But you get the idea.

Both positive and negative economic outlooks can have a direct effect on the currency markets.

And the most commonly used measure of economic growth is GDP.

GDP stands for “Gross Domestic Product” and represents the total monetary value of all final goods and services produced (and sold) within a country during a period of time (typically one year).

GDP provides an economic snapshot of a country, used to estimate the size of an economy and growth rate.

Global Economy

The United States is still the world’s largest economy.

China is the world’s second-largest economy.

The United States and China together make up nearly 40% of the global economic GDP.

The top 15 economies represent a whopping 75% of the total global GDP.

Capital Flows

Capital Flows Globalization, technological advances, and the internet have all contributed to the ease of investing your money virtually anywhere in the world, regardless of where you call home.

You’re only a few clicks of the mouse away (or a phone call to your folks living in the Jurassic era of the 2000s) from investing in the New York or London Stock exchange, trading the Nikkei or Hang Seng index, or from opening a forex account with broker to trade U.S. dollars, euros, yen, and even exotic currencies.

Capital flows measure the amount of money flowing into and out of a country or economy because of capital investment purchasing and selling.

The important thing you want to keep track of is capital flow balance, which can be positive or negative.

When a country has a positive capital flow balance, foreign investments coming into the country are greater than investments heading out of the country.

A negative capital flow balance is the direct opposite. Investments leaving the country for some foreign destinations are greater than investments coming in.

With more investment coming into a country, demand increases for that country’s currency as foreign investors have to sell their currency in order to buy the local currency.

This demand causes the currency to increase in value.

Simple supply and demand.

You can guess it, if supply is high for a currency (or demand is weak), the currency tends to lose value.

When foreign investments make an about-face, and domestic investors also want to switch teams and leave, and then you have an abundance of the local currency as everybody is selling and buying the currency of whatever foreign country or economy they’re investing in.

Foreign capital loves nothing more than a country with high interest rates and strong economic growth. If a country also has a growing domestic financial market, even better.

And again, as demand for the local currency increases so does its value.

Trade Flows and Trade Balance

International trade can be broadly distinguished between trade in goods (merchandise) and services. The bulk of international trade concerns physical goods, while services account for a much lower share.

World trade in goods has increased dramatically over the last decade, rising from about $10 trillion in 2005 to more than $18.89 trillion in 2019, according to reports.

We’re living in a global marketplace. Countries sell their own goods to countries that want them (exporting), while at the same time buying goods they want from other countries (importing).

Have a look around your house. Most of the stuff (electronics, clothing, doggie toys) lying around is probably made outside of the country you live in.

If you live in the United States, look at all the different countries that the U.S. trades with .U.S. Trade Flows

Every time you buy something, you have to give up some of your hard-earned cash.

Whoever you buy your widget from has to do the same thing.

U.S. importers exchange money with Chinese exporters when they buy goods. And Chinese imports exchange money with European exporters when they buy goods.

All this buying and selling is accompanied by the exchange of money, which in turn changes the flow of currency into and out of a country.

Trade balance (or balance of trade or net exports) measures the ratio of exports to imports for a given economy.

It demonstrates the demand for that country’s goods and services, and ultimately its currency as well.

If exports are higher than imports, a trade surplus is likely occurs and the trade balance is positive.

If imports are higher than exports, a trade deficit occurs, and the trade balance is negative.

Exports > Imports = Trade Surplus = Positive (+) Trade Balance

Imports > Exports = Trade Deficit = Negative (-) Trade Balance

Trade deficits have the prospect of pushing a currency price down compared to other currencies.

Net importers first have to sell their currency in order to buy the currency of the foreign merchant who’s selling the goods they want.

When there’s a trade deficit, the local currency is being sold to buy foreign goods.

Because of that, the currency of a country with a trade deficit is less in demand compared to the currency of a country with a trade surplus.

Trade surpluses tend to experience currency appreciation.

It is in more demand, helping their currency to gain value.

It’s all due to the DEMAND for the currency.

That’s because when exporters convert the foreign currencies they earn abroad into their domestic currency, this tends to put upward pressure on the domestic currency.

Currencies in higher demand tend to be valued higher than those in less demand.

The Government: Present and Future

Government After the Great Financial Crisis (GFC) caused the Great Recession during the late 2000s, all eyes were glaringly watching their respective country’s governments, wondering about the financial difficulties being faced, and hoping for some sort of fiscal responsibility that would end the woes felt in our wallets.

A decade later, we now face a similar situation as the world tries to navigate a global health crisis and economic collapse caused by the coronavirus (COVID-19) pandemic.

Instability in the current government or changes to the current administration can have a direct bearing on that country’s economy and even neighboring nations. And any impact on an economy will most likely affect exchange rates.

Technical Factors That Can Affect Currency Exchange Rate Fluctuations

When we talk about technical factors, we would also be talking about Technical Analysis Methods.

Technical Factor can be the framework in which traders influence price movement.

The theory is that a trader can look at historical price movements and determines the current trading conditions and potential price movement.

Someone who uses technical analysis is called a technical analyst. Traders who use technical analysis are known as technical traders.

The main evidence for considering technical factor or using technical analysis is that, theoretically, all current market information is reflected in the price.

Technical traders generally ascribe to the belief that “It’s all in the charts!”

This simply means that all known fundamental information is priced into the current market price.

If price reflects all the information that is out there, then price action is all one would really need to make a trade and cause price fluctuation depending on the strength in supply or demand.

Technical analysis looks at the rhythm, flow, and trends in price action.

Now, have you ever heard the old adage, “History tends to repeat itself“?

Well, that’s basically what technical analysis or factor is all about!

If a certain price held as a major support or resistance level in the past, forex traders will keep an eye out for it and base their trades around that historical price level.

Technical analysts look for similar patterns that have formed in the past and will form trade ideas believing that price could possibly act the same way that it did before.

Technical analysis is NOT so much about prediction as it is about POSSIBILITY. 

And technical factor or analysis may determine possibilities of the future direction of price.

In the world of trading, when someone says “technical analysis or factor”, the first thing that comes to mind is a chart.

Technical analysts use charts because they are the easiest way to visualize historical data!

Technical analysts live, eat, and breathe charts which is why they are often called chartists.

Chartists believe that price action is the most reliable indicator of future price movement.

You can look at past data to help you spot trends and patterns which could help you find some great trading opportunities.

What’s more is that with all the traders who rely on technical factors or analysis out there, these price patterns and indicator signals tend to become self-fulfilling.

As more and more forex traders look for certain price levels and chart patterns, the more likely that these patterns will manifest themselves in the markets.

You should know though that technical analysis is VERY subjective.

Just because you and your gang are looking at the exact same chart setup or indicators doesn’t mean that they will come up with the same idea of where price may be headed to.

The important thing is that you understand the concepts under technical factors and, or analysis so you won’t get nosebleeds whenever somebody starts talking about Fibonacci, Bollinger Bands, or supports and resistance levels.

Now we know you’re thinking to yourself, “Geez, these guys are smart. They use crazy words like ‘Fibonacci’ and ‘Bollinger’. I can never learn this stuff!”

Sentiment Factor That Can Affect Currency Exchange Rate Fluctuations

Understanding of sentiment factor or analysis can be used to gauge how other traders feel or may affect, whether it’s about the overall currency market or about a particular currency pair.

Earlier, we said that price action should theoretically reflect all available market information. Unfortunately for us forex traders, it isn’t that simple.

The forex markets do not simply reflect all of the information out there because traders will all just act the same way. Of course, that isn’t how things work.

This is why sentiment analysis is important. Each trader has his or her own opinion of why the market is acting the way it does and whether to trade in the same direction of the market or against it, and thereby causing the general price movement.

The market is just like Facebook – it’s a complex network made up of individuals who want to spam our news feeds.

Kidding aside, the market basically represents what all traders – you, Warren Buffet, or Celine from the donut shop – feel about the market.

Each trader’s thoughts and opinions, which are expressed through whatever position they take, helps form the overall sentiment of the market regardless of what information is out there.

The problem is that as retail traders, no matter how strongly you feel about a certain trade, you can’t move the forex markets in your favor.

Even if you truly believe that the dollar is going to go up, but everyone else is bearish on it, there’s nothing much you can do about it (unless you’re one of the GSs – George Soros or Goldman Sachs!).

As a trader, you have to take all this into consideration. You need to perform sentiment analysis.

It’s up to you to gauge how the market is feeling, whether it is bullish or bearish.

Then you have to decide how you want to incorporate your perception of market sentiment into your trading strategy.

If you choose to simply ignore market sentiment, that’s your choice. But hey, we’re telling you now, it’s your loss!

Sentiment analysis is often used as a contrarian indicator.

There are a couple of ideas why this is.

One idea behind this is if EVERYONE (or almost everyone) shares the SAME sentiment, then it’s time to go hipster and trade against the popular sentiment.

For example, if everyone and their mamas are bullish EUR/USD, then it might be time to go short.

Why? Unfortunately, you’ll have to go further down the School to find out!

Another idea is that most retail forex traders (unfortunately) suck. Depending on where you find statistics, between 70-90% of retail traders lose money.

So if you know that these all these unprofitable traders who are usually wrong are all currently long EUR/USD….well, then it might be a good idea to do the opposite of what they do!

Being able to put economic or fundamental factor and analysis into consideration, understanding technical factor and analysis, and gauge market sentiment aka sentiment analysis or factor can be important tools in your toolbox that can help you determine currency exchange rate fluctuation.