Currency exchange rates, like stock prices, constantly move up and down in a never-ending cycle. To look at a weekly, monthly, or longer-term chart, it might appear that all those squiggly price lines are random, but they’re not. And because share prices and international exchange rates are not random, millions of people take part in the buying and selling of securities and currency pairs every minute of every day. It’s a fact that forex trading online has become a worldwide phenomenon.
Stock enthusiasts spend untold effort trying to discern which economic factors, both macro and micro, affect the value of their favorite company’s shares. Likewise, forex traders do the same when it comes to how one currency is priced against another. What are the factors that affect that relationship, and how can forex traders use real, objective data to make more informed decisions about how a given nation’s denominated money is likely to perform over long- and short-time spans? Here’s a brief guide to several key factors that have the potential to affect the strength, and thus the value, of international currencies.
Rate of Inflation
From a nation’s point of view (and that’s a good way to think when analyzing this kind of data), inflation rates and the value of local money travel in opposite directions. For example, you can look at historical charts and see what has happened to the strength of the Japanese yen when that nation was suffering from high inflation. For active investors, the general rule to remember is inflation up, local currency down. The economic concept behind the rule is that inflation makes money weaker, which directly plays into the relative strength of individual currencies. All other things being equal (even though they never are), nation A’s money will be more potent than nation B’s as long as A has a lower rate of inflation than B.
BOT (Balance of Trade)
The good thing about inflation and BOT (the balance of trade), is that the data is easy to look up online. You don’t need to dig deep to find relevant statistics on any nation’s BOT, inflation rate, and other relevant components of monetary strength, or the value of the local money. The term BOT refers to whether a nation is a net exporter or net importer of goods. There are a few other, more complex pieces of data involved, but the net trading statistic is the one with the most weight. Using nations A and B as examples, if A is a net exporter, its leaders prefer a locally denominated money that is weak. Such weakness allows all those foreign buyers to get bargains on the goods they purchase.
Likewise, when A is a net importer of goods, it helps A’s cause to have a very strong currency. With that power, they are able to buy more without having to spend more. The principle works on an individual level as well. What’s the first thing you do after deciding to travel abroad? You look up the exchange rate and see how strong your buying power will be during your vacation.
National governments can take all sorts of actions, called fiscal policies, to affect the buying power of their money. The two main components of this category are tax laws and government spending. Governments that spend more than they have (called deficit spending) and maintain high tax rates tend to weaken their money’s buying power relative to other nations.
Manipulation by Central Banks
There are dozens of ways that national governments can manipulate their economies, for better or worse. In centrally planned economies (like those of the People’s Republic of China, Cuba, North Korea, and South Africa), manipulation is the primary, but usually an ineffective way, of controlling the strength of the nation’s money. One of the most powerful tools leaders have in this category is interest rate manipulation. Federal banks often set arbitrary interest rates higher or lower depending on what effect their think it will have. They are often wrong and end up changing course rather quickly. The general rule is that when interest rates go up, the buying power of the local money also rises.
Putting It All Together
How to put all this seemingly disparate knowledge together into a workable trading plan? For starters, it helps to stay on top of relevant new stories about global markets and events. Combined with a solid grasp of the above fundamental factors, a general knowledge of the world economic scene will give a diligent trader a much better chance of earning a profit from forex trading.