Understanding Which Primers Drive the Forex Markets
Good Traders Know Their Fundamental
“This is like asking a doctor whether he would prefer treating a patient with diagnostics or with a chart monitoring his conditions. You need both.”
-Bruce Kovner, one of the largest and most seasoned currency speculators in the world
Four Basic Economic Indicators Explained
1. Economic Growth
An indicator for economic growth is the country GDP. An expanding GDP due to strong economic growth will mostly bid up the currency due to investors’ desire to participate in the currency strength. You may want to take note that a runaway inflation will also causes GDP to expand and this will result in the currency weakness.
2. Interest Rates
Healthy economic growth will bring about an increase in speculative activities. Government will begin to increase interest rates in order to curb excessive speculation.
The increased in interest rates will result in currency traders flocking to the currency and bidding up its value. This is because they are always seeking to achieve high yields in return for their money.
The one exception to this scenario is if the central bank raises rates not as a policy response to rapid growth but as a means of curtailing runaway inflation. This will result in the weakening of the currency.
A high interest rate in a currency does not guarantee appreciation if it’s a result of high inflation rather than strong economic growth.
3. Trade Balance
Trade balance is the flow of goods and services between two countries. A surplus trade balance consists of exporting more than is imported. A trade deficit means importing more than its’ export. Goods and services are taken into account in trade balance only.
A surplus trade balance will mean that currency will appreciate as other countries are bidding up the price to purchase its goods and services. A deficit trade balance will depreciate the currency as it is selling more of its currency to buy goods and services from the rest of the world.
4. Political Stability
Forex market dislikes political instability because it caused great uncertainty to future economic growth. Countries with strong economic growth will often see their currencies decline if there is even a hint of political upheaval, eg political scandal or corruption within the government.
3 Theories that Attempt to Influence the Currency Market in the Long Run
Before we discuss the theories, I will highlight that these theories will affect currency market to a certain extent, however these theories have limitations. Theories are called theories because they made certain key assumptions which may not be the case in reality.
Trading forex market based solely on these theories is not recommended. And these strategies are fundamentals that influence the long term directions of currency. The period for these factors to influence currency directions may be 5 to 20 years.
It is important that investors understand these fundamentals that drives the currencies in the long run even though it may not necessary reflect today conditions.
What is Balance of Payments Theory
Balance of Payments consists of 2 accounts: the current account and the capital account;
Current account measures trade in tangible such as manufactured goods. Surplus or deficit between exports and imports is called the trade balance. A surplus trade balance consists of exporting more than is imported. A trade deficit means importing more than its’ exports.
Capital account measures flows of money such as investments for stocks or bonds.
Note: Capital account is described but this model only consider money inflow and outflow from current account.
Balance of Payments Theory
Countries that import more than exports have more money outflow than inflow, they are said to have a trade deficit. While countries that have more exports than imports will experience more money inflow than outflow, they are said to have a trade surplus.
Balance of Payments theory states that countries with trade deficits will experience currency depreciation because more of the nation currencies are sold in the market to import goods from abroad. The selling pressure causes the nation currency to depreciate against the other currencies.
Similarly, countries with trade surplus will experience an appreciation of nation currency. This is because more goods are sold abroad, and foreign countries have to buy nation currency in order to purchase goods. The buying pressure will appreciate nation currency against the other foreign currencies.
In general, countries might experience positive or negative trade. It is important that countries achieve a balance such that this deficit trade may not go on for a substantial period of time such that it is detrimental to the nation economy. Policy should be carried out to revert trade deficit back to surplus in the next calendar year.
The balance of payment model focuses on traded goods and services while ignoring international capital flows. It is until 1990s that capital flows plays a significant part in influencing the country exchange rate.
Hence, a country may have a trade deficit but because of it large capital inflow, in turn balances the total money flow. This model has failed to take into account the capital money flow which has since become significant in the current years.
This model holds that exchange rates are determined by nation monetary policy.
A tight monetary policy will mean that the nation central bank sell its’ equity investments and bonds in the open market to the public. Hence, these actions will decrease the money supply which will lead to an appreciation of nation currency.
While an easing of monetary policy by central bank will mean that the central bank buy equity and bonds back from the public in the open market. As a result, this will increase the nation money supply, leading to depreciation of its currency.
Several factors that influence exchange rates:
1. Nation money supply
2. Estimated future levels of a nation money supply
3. The growth rate of a nation money supply
This model is more effective in preventing a nation currency from sharply devaluation than pushing for currency appreciation. Very few economists solely stand by this model because it does not take into account trade flows and capital flows.
Real Interest Rate Differential Theory
The interest rate theory states countries that have high interest rates will see their currencies appreciate in value; while countries with low interest rates should see their currencies depreciate in value.
Basics of the Model
When a nation interest rates are raised, international investors will discover that the yield of that nations’ currency is more attractive and hence will shift their money there. This process will mean that investors will have to buy the nation currency in order to shift their money over there to take advantage of its high yields. This will cause the nation currency to appreciate in value.
When interest rates are lowered, international investors will find a better place to put their money so that they can receive better yields. This will cause investors to sell the nation currency so that they can move it abroad. As a result, this strong selling pressure will cause the currency to lose its value.
Another term for this phenomenon that investors are always in the pursuit for a higher yields location to park their money is called carry trade.
The main weakness for this model is that it does not take into account a nation current account balance, relying on capital flows instead. Factors such as political stability, inflation and economic growth are also not taken into consideration. Hence, this model may not work all the time.
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