As with almost anything, a currency’s value is dependent upon the demand and supply, and so in learning how to trade forex we need to understand what it is that affects their levels. There are, in fact, many determinants of the demand and supply but they all tend to fall into one of three main categories. These are some of the main determinants:
Economic – Both fiscal and monetary policy can impact on the strength of a nation’s currency. As we have seen in the UK in recent years, the market tends to react negatively to the widening of a budget deficit – it reacts similarly in cases of a trade deficit. As expected, during times of a narrowing budget deficit and a trade surplus – signaling the strength of a nation’s economy – the value of the currency will rise. Naturally, inflation has an impact upon the value of a currency as it reduces the spending power of those who use it. A general rise in the price of goods simply means your money doesn’t go as far and is, therefore, worth less resulting in reduced demand for that currency. Values tend to fluctuate more than usual around major announcements such as GDP and employment levels – a time where trading on a fixed spread would be beneficial.
Political – National and international political stability can have a huge impact on the value of a nation’s currency. During times of political unrest there is increased uncertainty and this is factored into the strength of a currency since demand is likely to have decreased. It can have a negative impact both directly and indirectly through the fall in foreign investment and economic development. It should be noted that the opposite effect can also occur where a political party, perceived to be more stable, comes into power and improved sentiment spreads through the population and onto foreign investors and speculators.
Market Sentiment – During times of uncertainty, on a national and international basis, investors often react by seeking to relocate their assets to more certain climates in order to protect their investment. Gold is often perceived as one of these more protected realms due to it’s stability, as is the USD. During such occurrences a greater demand is bestowed upon these safer assets and so their value rises in comparison to the weaker currencies.
Market sentiment is heavily based upon what traders think is going to happen – should sentiment be positive then during this time the value of an asset will rally, but when the expected announcement is finally given, often you will see that the value then moves back on itself. This is partly because the market has been ‘over bought’ (or ‘over sold’) and partly because the efficiency of the markets means that the good sentiment of investors had already been built into the value, so by the time of the announcement the value was, essentially, too high.
Note that fundamental analysis can only take you so far in trading Forex as it is very technical and so, as a trader, you need to stay on top of this. When choosing a Forex broker you should make sure that they have a charting package that you are comfortable with. Many will offer a demo account for you to ‘trial run’ their platform.