5 Factors That Influence Forex Trading

5 Factors That Influence Forex Trading

Reading Time: 7 Minutes

Currency trading takes place in the foreign exchange (Forex) market, the world's biggest and busiest financial market. Ranging from monetary policy and macroeconomic indicators to geopolitical global events, multiple factors influence the Forex market (and, by extension, Forex traders) daily.

Understanding these influences is crucial for Forex traders as they can significantly elevate volatility across currency pairs, including the majors, minors and exotics.

Interest Rates: The Price of Money

Most are aware that central banks set interest rates for their respective countries: the price of borrowing money. They’re a big deal in the Forex market.

At its core, higher interest rates, or the expectation of higher interest rates, can underpin a domestic currency as demand increases as investors seek higher yield; this is particularly the case if rates are higher (or expected to be higher) relative to other countries’ currencies. For example, suppose the US Federal Reserve increases the Fed funds target rate (or is expected to). In that case, the US dollar (USD) typically strengthens and can help form a long-term bias that trend-following strategies welcome. Conversely, lower rates, or the expectation of lower rates, relative to other countries can trigger a depreciation in the domestic currency.

Economic Indicators: The Heartbeat of the Economy

Imagine economic indicators as your body's vital signs, but instead of checking your pulse, you're checking an economy’s health.

Three of the most widely monitored economic indicators (macroeconomic measures that focus on economic aggregates) are economic growth (Gross Domestic Product [GDP]), the unemployment rate, and inflation (the average price level). 

• GDP: Think of GDP as the economy's scoreboard. A high real GDP growth rate indicates a robust economy that demonstrates a growing output of goods and services and thus can attract foreign investors. The incoming influx of investment, therefore, can increase the demand for the country’s currency and lead to appreciation in its value.
• Unemployment Rates: Lower unemployment means more people are employed, and this generally translates to more disposable income, which benefits the economy. Note that GDP and unemployment are inversely correlated. For example, economic growth tends to accommodate lower unemployment and vice versa.
• Inflation: Central banks monitor inflation indicators as one of the primary factors to help formulate monetary policy, including overnight interest rate adjustments. Moderate inflation is typically a sign of a growing economy (most developed countries work with an inflation target of 2% per year). Still, excessive inflation can erode purchasing power and deter foreign investment.

Economic data that aligns with the longer-term trend (created by the central bank) generally provides higher probability trading opportunities. However, economic releases not aligning with the bigger picture can also provide trading opportunities. As an example, a stronger-than-expected inflation release, at a time when the Fed is projecting rate cuts, can provide a short-term move higher to trade, but unless the release has enough weight behind it to potentially alter the longer-term bias, it is eventually likely to be sold into. Think of the economic indicators as a way of gauging a short-term bias and the central bank’s guidance and monetary policy as a means of providing the longer-term trend.

Political Stability

Countries with stable governments tend to attract more foreign capital, which can lead to appreciation in the country’s currency. On the other hand, countries experiencing political turmoil or uncertainty may see their currency value decline due to the risk of instability deterring foreign investors. Political stability also affects a country's ability to attract foreign investment and manage public and government debt.

For example, a stable political climate in Canada or India can enhance investor confidence that would lead to an increased demand for the Canadian dollar (CAD) or Indian Rupee (INR) respectively.

Speculation

Traders bet on the direction of currencies based on their analysis/expectations. This, of course, can lead to increased volatility. For example, if traders anticipate that a central bank will raise interest rates, they might buy the currency in advance, leading the domestic currency to appreciate even before the interest rate decision is announced (if at all).

Geopolitical Events

Last but not least, geopolitical events can send shockwaves through the Forex market and other financial markets. Natural disasters, oil price shocks and wars are just a few examples. These events are the wild cards that can turn market trends on their heads overnight and are notoriously difficult for Forex traders to trade; the events are often unscheduled and have highly uncertain outcomes.

For instance, geopolitical tensions in the Middle East can affect oil prices and they can influence the currencies of oil-exporting and importing countries.

The Currency Climax

As we look to the future, the Forex market will evolve and be influenced by global economic policies, technological advancements, geopolitical shifts and perhaps other new factors. Traders who stay informed, adapt to new information, and are disciplined in their trading strategies will be better positioned to navigate the Forex market.