Understanding the Key Factors that Affect Exchange Rates in Forex Trading

Deepen your understanding of factors that affect exchange rates with FOREX.com.

Investors often hesitate to invest in the foreign exchange (forex) market, as its sheer size and volatility can be daunting. Geopolitical relations and current events have a major impact on currency exchange rates so the forex market is more volatile than traditional stocks or bonds.  

But most short-term fluctuations are chalked up to market noise. Identifying the fundamental factors affecting exchange rates can help traders capitalize on market fluctuations and boost their profit margins. 

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Understanding Exchange Rates

The exchange rate refers to the value at which one currency can be exchanged for another. At the time of writing, the USD/CAD exchange rate stood at 1.35, while the USD/EUR was 0.93. This means that one U.S. dollar buys 1.35 Canadian dollars but only 0.93 Euros. 

Traders essentially buy one currency at the rate in which one currency can be exchanged for another in the forex market. If traders expect a currency such as the U.S. dollar to appreciate against the Euro, they will buy USD/EUR currency pair (go long). If the consensus is that USD will plummet relative to EUR, traders will sell, or short, the major currency pair. 

Common Economics That Impact Forex Traders

Several fundamental factors cause exchange rates to rise or fall. Understanding the primary economic factors influencing the U.S. dollar can help amateur traders build a solid foundation regarding forex trading, as the greenback was one side of approximately 88% of all forex trades as of April 2022, according to the Bank for International Settlements (BIS). 

Inflation Rates

Inflation typically has a negative impact on a currency and the corresponding exchange rate. The purchasing power of a currency plummets during periods of inflation, causing it to depreciate relative to foreign currencies. 

As the cost of goods and services rise in a home country, the demand for them falls in the international market. As a result, the demand for the corresponding currency declines as well, causing its value to fall with respect to other currencies. For instance, because of the hyperinflation crisis in Sri Lanka in 2022, its central bank intervened to devalue the Sri Lankan rupee by 15% in March.

Terms of Trade

Terms of trade (TOT) is the value of a country’s export prices with respect to its import prices. It is derived by dividing total export prices by import prices. A positive TOT ratio indicates the total value of exports is higher than the total value of imports. Consequently, the demand for domestic currency is higher in the international market, reflecting currency strength. But if imports exceed exports, the value of the domestic currency tends to fall, causing the equivalent exchange rates to depreciate. 

Government Debt

Government debt reflects the overall strength of an economy and market confidence in its legal tender. A country with a very high debt level runs the risk of default, which will result in the currency depreciating. The level of federal debt typically affects the market faith in a currency, and any change in the total borrowings has a direct impact on its exchange rates relative to other currencies. 

The U.S. hit its debt ceiling limit on Jan. 19, raising alarms regarding the government’s ability to meet its payment obligations. If Congress fails to pass a resolution to raise the debt ceiling, the U.S. dollar could fall significantly. 

Recessions

Exchange rates tend to fall during periods of economic downturn or recession. As the aggregate demand and consumer spending fall, the currency’s value also declines with respect to other foreign fiat currencies. Recession warnings issued last year by analysts and economists caused the U.S. dollar to fall late last year. 

The U.S. Dollar Index has declined by 3.7% over the past three months despite the Federal Reserve’s persistent rate hikes. The reserve currency index hit its nine-month low on Feb. 1 amid recession warnings and the Fed’s signal for slower rate hikes for the upcoming months. 

Political Stability and Performance

Geopolitical tensions have caused forex market volatility to multiply over the past few years. Current market and political news play an important role in influencing exchange rates and often cause wild swings in the forex market. Illustrating with an example, the Russian ruble hit its all-time low after the country waged a war against Ukraine last February.

Also, the Turkish lira hits a new record low against USD after the devastating earthquake as concerns regarding the economic stability of the region were brought into question. The economic crisis in Pakistan has caused the Pakistani rupee to fall heavily against the greenback. 

Forex Trading Demystified

While the daily fluctuations in exchange rates can appear daunting, fundamental factors typically have a long-term impact on exchange rates, while the impact of daily news on currencies is typically recovered intraday or within the short term. An economy’s health, growth prospects and overall stability are the primary factors you should consider before trading the respective currency. 

Analyzing a currency’s relative performance with other major currencies is important. For instance, almost all economies in the world were affected by raging inflation levels last year, causing major currency fluctuations. Also, the U.S. dollar is expected to remain strong against European currencies and the Chinese yuan despite the recession concerns, primarily because of the economic stability of the nation. 

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