The Foreign Exchange Market
The currency market is one of the most sophisticated markets in the world, attracting trillions of dollars per day in volume from central banks, corporations, hedge funds, and individual speculators. It operates on a 24-hour basis, beginning with trading in Wellington, New Zealand, and continuing on to Sydney, Australia; Tokyo, Japan; London, England; and finally, ending with New York before the whole cycle begins all over again. Although the currency market exists mainly for importing and exporting activities and for corporations to hedge their foreign exchange risk, like all markets, there are speculators. In the forex market, it happens that 80% of all trading activity is speculative in nature. However, of all the influences on the foreign exchange markets, there are five key factors that are the main drivers of movements, and we will rank and explain them in terms of importance:
I. Interest Rates
Yield is the no. 1 influencer of exchange rates between currencies. Every currency’s country has a central bank that sets the interest rate on the currency. What this means is that when the central bank of a country moves the interest rate either up or down, it affects the movement of the currency substantially. This is because, in general, speculators will buy currencies with high yields and finance those same purchases with low yielding currencies. One example is the USD/JPY pair, which is often used for carry trades. In the fall of 2006, the short-term rates in the U.S. were at 5.25%, while in Japan they were only 0.25 %. In this case, traders would buy long on dollars in order to receive 525 basis points of interest and sell yen to only pay 25 basis points on that end of the trade, making a total spread of 500 basis points, allowing to not only gain profit from interest income flows, but also from capital appreciation (Please note: You will pay interest when you sell a currency with a high interest yield and in exchange buy a currency with a low interest yield). Similarly, when the Bank of England surprisingly raised interest rates in August of 2006 from 4.5% to 4.75%, the spread on the popular GBP/JPY pair widened from 425 basis points to 450 basis points, driving the pair to have huge speculative flows in the currency as traders tried to take advantage of the new spreads, which brought the currency up a stunning 700 points within just three short weeks.
II. Economic Growth
The country’s economic growth, or as otherwise expressed by gross domestic product (GDP), is the second most influential factor on currency movements. This is because the stronger a country’s economy becomes, the more likely it is for the country’s central bank to raise rates in order to tame inflation that comes about when there is growth; there's also a much larger chance that there will be large flows of foreign capital into the country's fixed income and equities markets. The EUR/USD exampled this relationship well in the time between 2005 and 2006. In 2005, the euro zone lagged behind significantly in terms of GDP growth, averaging a meager 1.5% rate throughout the year, while the U.S. expanded at a healthy 3%. This led to a large drop in the EUR/USD in 2005, but in 2006, the euro zone began to grow and eventually overtook the U.S.’s growth, and the EUR/USD rallied.
III. Geopolitics
The influence of geopolitics on currencies is large and can best be understood through realizing that speculators run first, and ask questions later. They will quickly run to the sidelines until they are certain that the political risk has dissipated. Therefore, the rule of thumb when dealing with currency is that politics almost always trumps standard economics. One example of this influencer in action was the USD/CAD in May of 2005. Despite Canada enjoying the position of no.1 crude exporter to the U.S, then Canadian Prime Minister Paul Martin was facing a no-confidence vote from accusations of past Liberal Party corruption. Despite the country’s
*Leveraged foreign exchange trading carries a high level of risk, and may not be suitable for all investors. The possibility exists that you
could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose.
economics signaling a rally, the CAD stayed relatively weak to the USD until finally weeks later, currency traders began to focus on Canada’s stellar economic fundamentals instead and the USD/CAD plunged 200 points.
IV. Trade Flows vs. Capital Flows
Trade flows (how much income the country brings in through trade) and capital flows (how much foreign investment the country attracts) are critical components of currency movement. Still, the reason why it’s only the fourth influencer is that some countries are more sensitive to trade flows, while others are more dependent on capital flows. In this way, it’s not possible to apply the weight of trade flows and capital flows to the same country. In general, trade flows matter much more for commodity-dollar currencies such as the Canadian, Australian, and New Zealand dollars. In Canada, oil is the primary source of revenue; in Australia, industrial and precious metals dominate trade; and in New Zealand, agricultural goods are a crucial source of income. Trade flows are also very important for other export heavy countries such as Japan and Germany. Though for countries such as the U.S. and the U.K., due to very large liquid capital markets, investment flows are much more important than trade flows. These countries have financial services that are extremely important. In fact, US financial services represented 40% of the total profits of the S&P 500. On the surface, the U.S.’s record multi-billion dollar deficit should make the currency depreciate significantly, but historically, it has not been the case. The U.S. offsets this deficit by attracting more than enough surplus capital from the rest of the world. Currently, the massive deficit in trade flows does not affect the U.S. but should the U.S. be unable to attract enough capital flows to offset this deficit, the currency may weaken. Understanding this, one can easily see why studying the trade flows and capital flows of a country can be so important when gauging which direction a currency may move.
V. Mergers and Acquisition activity
Although this may be the fifth factor in importance for what can affect long-term currency movements, it can be the most powerful near-term-movement influencer of the five. The basic definition of mergers and acquisitions as it pertains to currency is when a company from one economic region wants to make a transnational transaction and buy a corporation from another country. For example, if a European company wishes to buy a Canadian asset for C$20 billion, it would have to buy that currency through the foreign exchange market because of the difference in currencies. Typically, these types of deals are not price sensitive but rather time sensitive because the acquirer may have a date by which the transaction must be completed. Due to this time constraint, M&A flows can have very strong temporary effects on forex trading, sometimes skewing the natural course of the order flow. One recent example was with the USD/CAD pair, which should have responded to weakness in Canadian economic data by rallying; however, due to an extremely large demand for Canadian corporate assets from investors in Asia, the Middle East, and Europe, there were huge influences on the CAD, which kept it up against the dollar, and the pair remained near its all-time lows even as oil sustained a major correction.
Conclusion
These are the five basic building blocks of forex analysis. These five factors are fairly straightforward, but actual currency trading is not as easy as just looking at these five building blocks, that is, currency trading involves an endless interplay and combination of all these five components, and by becoming familiar with these ideas, you will be well on your way to being able to understand and trade in the biggest financial market in the world, the forex market.
The currency market is one of the most sophisticated markets in the world, attracting trillions of dollars per day in volume from central banks, corporations, hedge funds, and individual speculators. It operates on a 24-hour basis, beginning with trading in Wellington, New Zealand, and continuing on to Sydney, Australia; Tokyo, Japan; London, England; and finally, ending with New York before the whole cycle begins all over again. Although the currency market exists mainly for importing and exporting activities and for corporations to hedge their foreign exchange risk, like all markets, there are speculators. In the forex market, it happens that 80% of all trading activity is speculative in nature. However, of all the influences on the foreign exchange markets, there are five key factors that are the main drivers of movements, and we will rank and explain them in terms of importance:
I. Interest Rates
Yield is the no. 1 influencer of exchange rates between currencies. Every currency’s country has a central bank that sets the interest rate on the currency. What this means is that when the central bank of a country moves the interest rate either up or down, it affects the movement of the currency substantially. This is because, in general, speculators will buy currencies with high yields and finance those same purchases with low yielding currencies. One example is the USD/JPY pair, which is often used for carry trades. In the fall of 2006, the short-term rates in the U.S. were at 5.25%, while in Japan they were only 0.25 %. In this case, traders would buy long on dollars in order to receive 525 basis points of interest and sell yen to only pay 25 basis points on that end of the trade, making a total spread of 500 basis points, allowing to not only gain profit from interest income flows, but also from capital appreciation (Please note: You will pay interest when you sell a currency with a high interest yield and in exchange buy a currency with a low interest yield). Similarly, when the Bank of England surprisingly raised interest rates in August of 2006 from 4.5% to 4.75%, the spread on the popular GBP/JPY pair widened from 425 basis points to 450 basis points, driving the pair to have huge speculative flows in the currency as traders tried to take advantage of the new spreads, which brought the currency up a stunning 700 points within just three short weeks.
II. Economic Growth
The country’s economic growth, or as otherwise expressed by gross domestic product (GDP), is the second most influential factor on currency movements. This is because the stronger a country’s economy becomes, the more likely it is for the country’s central bank to raise rates in order to tame inflation that comes about when there is growth; there's also a much larger chance that there will be large flows of foreign capital into the country's fixed income and equities markets. The EUR/USD exampled this relationship well in the time between 2005 and 2006. In 2005, the euro zone lagged behind significantly in terms of GDP growth, averaging a meager 1.5% rate throughout the year, while the U.S. expanded at a healthy 3%. This led to a large drop in the EUR/USD in 2005, but in 2006, the euro zone began to grow and eventually overtook the U.S.’s growth, and the EUR/USD rallied.
III. Geopolitics
The influence of geopolitics on currencies is large and can best be understood through realizing that speculators run first, and ask questions later. They will quickly run to the sidelines until they are certain that the political risk has dissipated. Therefore, the rule of thumb when dealing with currency is that politics almost always trumps standard economics. One example of this influencer in action was the USD/CAD in May of 2005. Despite Canada enjoying the position of no.1 crude exporter to the U.S, then Canadian Prime Minister Paul Martin was facing a no-confidence vote from accusations of past Liberal Party corruption. Despite the country’s
*Leveraged foreign exchange trading carries a high level of risk, and may not be suitable for all investors. The possibility exists that you
could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose.
economics signaling a rally, the CAD stayed relatively weak to the USD until finally weeks later, currency traders began to focus on Canada’s stellar economic fundamentals instead and the USD/CAD plunged 200 points.
IV. Trade Flows vs. Capital Flows
Trade flows (how much income the country brings in through trade) and capital flows (how much foreign investment the country attracts) are critical components of currency movement. Still, the reason why it’s only the fourth influencer is that some countries are more sensitive to trade flows, while others are more dependent on capital flows. In this way, it’s not possible to apply the weight of trade flows and capital flows to the same country. In general, trade flows matter much more for commodity-dollar currencies such as the Canadian, Australian, and New Zealand dollars. In Canada, oil is the primary source of revenue; in Australia, industrial and precious metals dominate trade; and in New Zealand, agricultural goods are a crucial source of income. Trade flows are also very important for other export heavy countries such as Japan and Germany. Though for countries such as the U.S. and the U.K., due to very large liquid capital markets, investment flows are much more important than trade flows. These countries have financial services that are extremely important. In fact, US financial services represented 40% of the total profits of the S&P 500. On the surface, the U.S.’s record multi-billion dollar deficit should make the currency depreciate significantly, but historically, it has not been the case. The U.S. offsets this deficit by attracting more than enough surplus capital from the rest of the world. Currently, the massive deficit in trade flows does not affect the U.S. but should the U.S. be unable to attract enough capital flows to offset this deficit, the currency may weaken. Understanding this, one can easily see why studying the trade flows and capital flows of a country can be so important when gauging which direction a currency may move.
V. Mergers and Acquisition activity
Although this may be the fifth factor in importance for what can affect long-term currency movements, it can be the most powerful near-term-movement influencer of the five. The basic definition of mergers and acquisitions as it pertains to currency is when a company from one economic region wants to make a transnational transaction and buy a corporation from another country. For example, if a European company wishes to buy a Canadian asset for C$20 billion, it would have to buy that currency through the foreign exchange market because of the difference in currencies. Typically, these types of deals are not price sensitive but rather time sensitive because the acquirer may have a date by which the transaction must be completed. Due to this time constraint, M&A flows can have very strong temporary effects on forex trading, sometimes skewing the natural course of the order flow. One recent example was with the USD/CAD pair, which should have responded to weakness in Canadian economic data by rallying; however, due to an extremely large demand for Canadian corporate assets from investors in Asia, the Middle East, and Europe, there were huge influences on the CAD, which kept it up against the dollar, and the pair remained near its all-time lows even as oil sustained a major correction.
Conclusion
These are the five basic building blocks of forex analysis. These five factors are fairly straightforward, but actual currency trading is not as easy as just looking at these five building blocks, that is, currency trading involves an endless interplay and combination of all these five components, and by becoming familiar with these ideas, you will be well on your way to being able to understand and trade in the biggest financial market in the world, the forex market.
Euro Exchange Rate
