What Affects Fluctuations in the Forex Market
Understanding the Forex Market
Being a forex trader, it’s necessary to know how the forex market functions fundamentally.
This includes knowing certain basic principles of the market such as the currency pairs, bid-ask spreads, leverage, margin requirements, and others. These principles will help you build a strong base that will help you understand the intricacies of the forex market and also make the right trading decisions.
What Causes Currency Fluctuations?
At the most basic level, currency fluctuations are caused by changes in the supply and demand of a given currency. When a specific currency is in demand for whatever reason, its value relative to other currencies may rise. When it is not in demand due to domestic economic downturns, for instance, then its value will fall relative to others.
Several factors can cause exchange rates to change, including:
- Interest rates: Central banks, such as the Federal Reserve or the European Central Bank, make monetary policy and set interest rates that influence currency values. Higher interest rates offer better returns on investments denominated in that currency, attracting foreign capital and increasing demand.
- Economic data: Indicators such as GDP growth, employment rates, and consumer spending affect perceptions of a country’s economic health and influence currency values.
- Political stability: Countries with stable governments and robust legal systems tend to have stronger currencies. Political turmoil can deter foreign investors, leading to currency depreciation.
- Inflation rates: Low inflation typically indicates a stable economy, boosting a currency's value. Conversely, high inflation can erode purchasing power and devalue a country's currency further.
- Foreign investment: Inflows of foreign capital into a country increase demand for its currency, leading to appreciation. Conversely, outflows of foreign trade can cause depreciation.
What is the Impact of These Factors on The Economy?
Merchandise Trade
This refers to a country’s imports and exports. In general, a weaker currency makes imports more expensive, while stimulating exports by making them cheaper for overseas customers to buy. A weak or strong currency can contribute to a nation's trade deficit or trade surplus over time.
For example, assume you are a U.S. exporter who sells widgets at $10 each to a buyer in Europe. The exchange rate is €1=$1.25. Therefore, the cost to your European buyer is €8 per widget.
Now let's say the dollar weakens and the exchange rate is €1=$1.35. Your buyer wants to negotiate a better price, and you can afford to give them a break while still clearing at least $10 per widget. Even if you set the new price at €7.50 per widget, which is a 6.25% discount from your buyer's perspective, your price in dollars is $10.13 at the current exchange rate.
Gross Domestic Product
Gross Domestic Product commonly known as the GDP, is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period. As a broad measure of overall domestic production, it functions as a comprehensive scorecard of a given country’s economic health.
The following formula calculates GDP:
GDP=C+I+G+(X−M)
where:
C for consumption or consumer spending, the biggest component of an economy
I for capital investment by businesses and households
G for government spending
(X−M) for (Exports − Imports), or net exports
A lower currency rate can affect international trade, investment, and tourism, which in turn can impact a country's GDP.
Interest Rates
Exchange rates are a key consideration for most central banks when setting monetary policy. A strong domestic currency exerts a drag on the economy, achieving the same result as a tighter monetary policy (i.e. higher interest rates).
Inflation
A devalued currency can result in inflation for countries, a sudden 20% decline in the domestic currency could result in imports costing 25% more, as a 20% decline means a 25% increase is needed to get back to the original price point.
Global Impact of Currency Fluctuations
Now you understand what causes market fluctuations and what the result is on the nations. We can now learn about the real-world examples of these factors in action.
Euro Fears (2010-2012)
Concerns that the deeply indebted nations of Greece, Portugal, Spain, and Italy would be forced out of the European Union led the euro to plunge 20% from 1.51 to the dollar in December 2009 to about 1.19 in June 2010. The euro recovered its strength over the next year, but that only proved temporary. A resurgence of EU break-up fears led to a 19% slump in the euro from May 2011 to July 2012.
You can look at this graph to check historical annual data of the Euro.
The Asian Financial Crisis of 1997-98
A prime example of the havoc caused by adverse currency moves is the Asian Financial Crisis, which began with the devaluation of the Thai baht in the summer of 1997. The devaluation occurred after the baht came under intense speculative attack, forcing Thailand's central bank to abandon its peg to the U.S. dollar and float the currency.
This currency contagion spread to neighboring countries such as Indonesia, Malaysia, and South Korea, leading to a severe contraction in these economies as bankruptcies soared and stock markets plunged.
You can learn more about this crisis here.
The Yen and Japan's Economy (1985-2008)
The yen experienced epic gyrations, starting with its rapid ascent after the March 1985 Plaza Accord of major industrial countries. Two distinct periods of endaka fukyo, or recession induced by a strong yen, occurred in the late 1980s and the early 1990s at critical phases of the monetary policy cycle.
You can check out the historical graph of USD/JPY here, and if you want to look deeper into the Japanese Yen’s gyrations you can read about it in the NBER working paper here.
Argentina Monetary Crisis (2018-2019)
Argentina offers a compelling example of how currency fluctuations can significantly impact a nation’s economy.
In 2018 and 2019, the Argentine peso (ARS) experienced severe depreciation, losing over 50% of its value against the U.S. dollar in less than two years. This drastic drop in the currency’s value had profound effects on the country’s economy, leading to a host of challenges.
You can learn more about this crisis from this research.
Conclusion and Final Thoughts
In the ever-evolving world of forex trading, understanding the factors behind market fluctuations is the key to unlocking your full trading potential. By delving into the intricate workings of the forex market, analyzing the impact of economic indicators and global events, and mastering both technical and fundamental analysis, you can develop a comprehensive trading strategy that positions you for long-term success.
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