How do Economic Factors Affect Exchange Rates?

How do Economic Factors Affect Exchange Rates?

Reading time: 7 minutes

The ever-shifting foreign exchange market (Forex [FX] market) can be both captivating and maddening in equal measure. Behind what appears to be random price fluctuation across global exchange rates lies a complex relationship of economic factors, and that is what this article will be exploring. 

Understanding the intricate economic interplay helps determine an economy’s position and a country’s currency value. 

The Top of The Tree: Central Banks

Everything begins with the central banks and their guidance: the biggest driver behind FX price action.

The policy-setting meetings (each country’s central bank meets approximately eight times per year) have a marked influence on currencies. Exchange rates largely move based on the expectations of future monetary policy. A country’s central bank that is expected to raise rates can be categorised by way of a ‘hawkish bias’; they’re essentially talking up the prospect of raising rates and this can see increased demand for the domestic currency. Cutting rates is also a possibility for central banks, stressing a ‘dovish bias’, and can see a depreciation in a country’s currency value. Although a little more complicated than this, the rationale behind this approach is that central banks with higher interest rates tend to have stronger currencies than those with lower interest rates. This can be referred to as interest rate differentials. 

This is why traders, investors, economists and analysts (and just about anyone who has an interest in the macroeconomic landscape) pay attention to what the central bank’s projections are and what key central bank speakers say when speaking at events and with financial news outlets.

GDP, Inflation and Jobs

Three economic indicators that frequently move the currency market are economic performance, or Gross Domestic Product (GDP), the inflation rate and the unemployment rate. These indicators, along with some second-tier data, can influence exchange rates, specifically when the actual release falls outside of the consensus range. 

• GDP represents the total value of all domestic goods and services produced over a given period. In the US, for example, GDP data is released in three parts throughout a quarter. So, as we come to the end of Q1, by the end of April we will see the Q1 GDP first estimate, also referred to as the advance estimate, followed by the preliminary estimate or the second estimate for Q1, and then the final value for the previous quarter which is the most concise number available. The advance reading tends to garner the most interest, however. Although it lacks as much data as additional revisions, the advance estimate provides traders and investors with an early look at US economic growth and hence you will often see Forex prices respond to this data, as well as equity markets and bonds.
• Inflation measures the rate of change in prices within an economy, essentially gauging the cost of living for a typical consumer based on a basket of goods and services. The Consumer Price Index (CPI) is the most widely-used measure and tracks the value of a basket of goods and services that the majority consume on a regular basis. For consumers, high inflation can lower purchasing power. High inflation also tends to be followed by higher interest rates, designed to squeeze consumption to slow inflation pressures to avoid an economy becoming overheated. Along with higher inflation and higher rates, an increase in the relative attractiveness of the currency of that country is often seen, particularly versus those with lower rates in other countries. 
• Unemployment, for the US at least, reflects the percentage of the labour force (the sum of employed and unemployed) currently jobless but sought employment in the last four weeks. When unemployment is low, and jobs are being added, it typically indicates economic growth and vice versa for high unemployment. Of note, there is a clear inverse correlation between GDP and unemployment: when one goes up, the other generally falls, and vice versa. 

How to Trade the FX Market Using Macroeconomic Fundamentals?

Again, the best place to start is with the central banks and expectations for the economy and short-term interest rates. The idea is to trade based on economic statistics that align with the central banks prevailing sentiment. Think about it like this. The central bank informs market participants what economic indicators they are watching (guidance). So, for instance, if the central bank is paying close attention to inflation data and CPI shows meaningful variance from the forecasted number, then reasonably aggressive price movement will be seen as investors readjust to the new information. What’s important to note is that the economic indicators create a short-term bias in the markets but the central bank creates a long-term trend. The higher probability trading opportunities, therefore, are found when these economic numbers are in harmony with the longer-term bias.

As an example, this year (2024), the US Federal Reserve (the Fed) is expected to begin cutting its Fed funds target range. The Fed projected three rate cuts in its latest Summary of Economic Projections and markets also forecast four rate cuts: the two are aligned for the first time in a while. With the expectation of rate cuts on the horizon, economic data that reveals a lower-than-expected actual value (traders often refer to this as a miss) will generally weigh on the US dollar (USD). Some traders may short immediately following a lower-than-anticipated economic release (though do be aware in highly volatile market conditions such as when news releases make the airwaves, slippage is often seen); others might wait and see if a pullback unfolds after the initial move has taken place. 

Some traders also look to trade into the news. If potentially high-impacting data is forecast to come in weaker than expected, selling into the event and exiting the position just ahead of the release (or upon release) is another route. You may have heard this as buy the rumour, sell the fact (or, in this case, sell the rumour, buy the fact). 

Conclusion

Whether you're a business owner managing international transactions, an investor seeking opportunities, or simply curious about the global economy, appreciating the interplay of economic factors and exchange rates empowers you to make more informed decisions and helps navigate the ever-changing tides of the market.