Forex is a highly volatile financial market. Currency prices are in constant flux, creating profitable opportunities and making investment difficult for forex traders at the same time. Why does forex fluctuate up and down?
Forex fluctuates up and down due to currency price changes. Many factors affect currency values, including economic indicators such as inflation rates, interest rates, unemployment, GDP, and money supplies. Political issues like wars, elections, and referendums also change a currency’s value.
In the following, we’ll discuss what causes currency value appreciation or depreciation, leading to constant forex fluctuations.
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Table of Contents
Economic Factors
A currency may go through changes due to economic reasons. Here are the most important ones:
Inflation Rates
The inflation rate is one of the most influential factors in forex fluctuations. The higher the inflation rate, the faster the goods and service prices go up. Although good economic growth comes with a small degree of inflation, significant inflation increases could lead to economic instability and currency devaluation.
Simply put, when inflation rises, the purchasing power drops, and people can’t buy what they used to. As a result, businesses can’t sell their products and services. Raising interest rates by central banks is the solution to this problem. This way, they stimulate people to put their money in banks instead of purchasing goods. The result is lowered demand for goods and decreased prices, leading to lower inflation rates.
However, it makes the national currency’s supply increase. When supply is higher, demand falls, and the currency value drops.
Government debt, budget deficit, government revenue from exports, government spending, recession, and gross domestic product can all affect a country’s inflation rates and its currency’s value appreciation or depreciation.
Interest Rates and Money Supplies
Monetary policies regarding money supply and interest rates can lead to a currency’s value fluctuation. Governments and central banks use these two factors to control their domestic currencies.
The money supply is the amount of circulating money in a specific country. The higher the money supply, the more that currency’s accessibility, and therefore, the lower the cost of money. If there’s too much money supply, the currency will decrease in value against other currencies. Plus, high money supplies lead to lower demand and, consequently, lower interest rates.
Simply put, the interest rate is the price at which people can borrow money. When interest rates are low, people get attracted to borrowing and thus spending money. Therefore, low interest rates help the economy grow.
However, with poor interest rates, the investors and lenders get lower ROI (return on investments), leading to lower exchange rates. If interest rates are low, traders become less willing to buy the currency. Instead, they sell what they have to avoid losing profits. This factor, in turn, will lead to higher supply and less demand, and the currency’s price will drop.
Sometimes, governments try to create price fluctuation intentionally through different economic tools. For example, they decide to lower a currency’s value to encourage exports and make imports less viable.
Government Debt
Government debt, both national and international, can cause inflation if it’s too high. When the government is in debt, it spends more than it takes in. Although the strategy may help achieve long-term growth, it can affect many economic sectors if not managed properly.
For example, it discourages foreign investment because the government will be more likely to default on its debts. It could also urge the government to issue more money to increase the circulation volume. Consequently, the currency supply will increase, leading to lowered prices.
On the other hand, smaller national debt results in a more stable and powerful economy, attracting more investors and leading to currency appreciation.
Politics
A country’s political status affects its currency and, therefore, has a massive bearing on forex. Since investment results are usually uncertain, foreigners prefer investing in countries with high political stability. When foreign capital increases in a country, its domestic currency value will appreciate.
On the other hand, political turmoil, wars, and nondemocratic systems make a country’s currency less attractive, leading to lowered demand. Foreign investors don’t like to invest in a country with unpredictable conditions.
Exchange rates may react negatively or positively to particular party elections or referendums. For example, if people elect a pro-economic-growth candidate, that country’s currency will grow in value. A famous example is the Brexit referendum, which affected England’s pound due to the political uncertainty it created.
International geopolitical events can weaken or strengthen a country’s national currency, as well, because currencies change relative to each other.
Forex traders should always monitor political news and events to predict official decisions and policies. Any changes in the regulations or monetary policies in a sector or industry can affect a domestic currency.
International Trades
When a country has lots of exported goods, it’ll see a rise in demand for its goods or services and, as a result, its currency. Foreign buyers have to convert their money into that country’s currency to purchase goods from it. The increased demand will lead to a higher value for that currency.
Besides, when a country has more exports than imports, the economy is more stable due to having a “trade surplus.” It results in more foreign exchange flowing into the said country and strengthening its national currency.
In contrast, if a country imports many goods from other countries, it has to change its money to other currencies. So, it spends more of its currencies in exchange for others. This situation can result in currency devaluation.
Traders
Market psychology refers to the traders’ perception of the market and currencies. Since the traders’ willingness to invest in a currency derives from this perception, it can greatly affect the price movements.
During unfavorable political or economic events, investors look into safer investment options. They engage in herd-like actions encouraged by the market uncertainty, referred to as the flight-to-quality behavior. In this approach, traders rush to buy or sell a specific currency, leading to price fluctuations.
They can also affect the forex market through speculation. If traders speculate that a currency’s value will rise, they demand more to increase future profits. Increased demand will raise the currency’s value.
External Forces
Sometimes, factors affecting a currency’s value aren’t inside that country. For instance, when two currencies compete, any change in one currency alters the other. If one currency devalues, the other one may go up in price.
That’s why forex traders have to analyze both countries’ political and economic conditions when they consider investing in a pair.
Other Capital Markets
The forex market doesn’t operate in a vacuum. So, it can experience high volatility created by other markets. Traders always watch global capital markets because they indicate an economy’s health. For example, if a country decides to sell off securities, it could signal changes in its economic conditions.
Commodities like oil can greatly influence many economies. In an oil-based economy, the currency value can increase after an oil price escalation and vice-versa.
Bond markets have similar impacts on forex due to their dependence on interest rates. So, if traders see fluctuations in treasury prices, it could lead to changes in exchange rates and, consequently, currencies.
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Conclusion
Many factors influence the forex market, leading to constant fluctuations even during one day. External and internal economic and political forces change currency prices.
Interest rate, inflation rate, government debt, budget deficit, and unemployment rate are among many economic forces that lead to forex fluctuations.
Political events and decisions in other countries, market psychology, and other markets can also fluctuate the forex market.
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