Fundamental Trading: The Major Currency Drivers

By , November 12, 2012

Takeaway: Keeping the major drivers in mind as you watch the market react to the individual releases will help you refine your processes and deepen your understanding of the other market players.

Fundamental Trading: The Major Currency Drivers
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Economic releases and news events are a huge force in the forex market. The U.S. GDP numbers and the Non-Farm U.S. Payroll numbers can send ripples across the market for weeks as short-term and long-term traders move on the data. From a wider perspective, however, economic releases aren’t the main driver of the market. There is a larger story in which economic releases are just chapters. In this article, we’ll look at those major driving forces in the currency market.

Everyone Is Interested in Interest

Most of the time, interest rates are the most powerful force in determining a currency’s value. Generally speaking, high interest rate currencies do better against their lower yielding counterparts - but that isn’t the whole story. More important than the actual interest rate are the direction, speed and potential range of interest rate changes. Basically, if the interest rate is going up (or down), traders want to know how fast and how much it can potentially change. Even though interest rates aren’t changed that often on average, speculation around possible changes drives currency speculation all year round.

Economic Growth…

A country with strong economic growth as shown in GDP numbers, job growth and so on, will usually see its currency appreciate against countries with weaker or slower growth. That said, the interest rate story can trump any growth story. However, if rates are about equal between two nations, then the growth story becomes the most important story by default.

... and Inflation

Of course, nothing in currency valuation is as easy as it first appears. Growth often runs hand-in-hand with inflation. Growth can be spurred by inflation and easy monetary policy, or it can come happen more or less naturally. Unfortunately, very few growth stories can avoid inflation for long. Many nations eventually try to "cash in" on the economic good fortunes by issuing more cash.

Inflation can be a tipping point in a currencies larger fundamental trend. Central banks, governments, traders and other forex market participants tend to look the other way as long high inflation is coupled with strong growth. In this case, the central bank will usually act to slow growth by upping interest rates, making interest rates the main driver again. If, however, high inflation is accompanied by a weakening growth picture, market players start to see a recession on the horizon and drive the value of a currency down. Similarly, central banks will generally react by loosening monetary policy and dropping interest rates, so - once again - the interest rate story takes over and carries on down.

Economic and Political Stability

Stability comes in a distant fourth on the list of currency drivers. Simply put, a particular currency may trade at a premium or a discount based on its economic and political stability.

This can be seen most clearly in the gap between market numbers and market reactions. Two currencies can show the exact same decrease in GDP and one will stay steady and the other will drop wildly. The difference is usually the market perception of the issuing nations. If a nation is seen as being politically and financially stable, then the currency will be given "goodwill" by the market and may even be a safe haven in times of economic uncertainty worldwide. If a country is perceived as being on shaky political or financial footing, then it will always trade at a slight discount to the numbers it puts up.

Putting Money On It

Knowing the major drivers of a currency’s value is only half the battle in fundamental forex trading. To put this knowledge into practice, you need to follow the economic releases around these drivers. Interest rates are easy to follow and well publicized, but accurately gauging a nation’s growth picture and/or real inflation numbers involves interpreting releases rather than just reading them. Keeping the major drivers in mind as you watch the market react to the individual releases will help you refine your processes and deepen your understanding of the other market players.

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Andrew Beattie has spent most of his career writing, editing and managing financial content as well as more general web site material in all its many forms. He is especially interested in the future of search and the application of analytics to the business world. He has been a long-time contributor to Investopedia.com and is currently venturing forth on ForexDictionary.
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