Forex traders rely on certain indicators to make trading decisions. Most of these indicators are related to the economic performance of the countries where traded currencies are domiciled. As such, traders rely heavily on economic information. Often, a trader subscribes to a particular information source that will be sending economic releases and analyses when significant events happen.

 

This article describes 5 key economic factors that cause fluctuations in currency values and foreign exchange rates.

1. Balance of Trade/Balance of Payments

Nations trade with each other and this trade creates imports and exports for each country. A country keeps record of its trading outcomes with other nations in its current account. This account also includes other transactions like earnings on foreign investments and debt.

When a country enters into transactions with another country, it spends its currency. Importing goods and services that are of more value than the value of goods and services exported in the same period can result into a trade deficit in the country’s current account. More exports than imports can create a trade surplus. The currency value of a country with a trade deficit reduces because more of the currency is being sold to make payments for the international goods. A trade surplus, on the other hand, is favourable to a country’s currency because more of the currency is demanded. Increased demand of a currency tends to push its price up.

2. Inflation Rate

 

Market inflation indicates changes in the purchasing power of a currency denomination and therefore exchange rates. In a country where the inflation rate is going up, depreciation (loss of value) is observed in the value of the country’s currency. However, some economy experts suggest that rising inflation rates can also have an upward (favourable) pressure on a currency’s value. This could happen when the central bank decides to increase rates to counter rising inflation rates.

It is important to stay up to date with fiscal and monetary policies put in place by the governments of countries for which you want to trade currencies. These policies usually have the greatest impact on economic decision making and consequently how major economic factors change.

3. Interest Rates

Forex rates are correlated with interest rates. An increase in interest rates in a country may cause the currency to appreciate. Higher interest rates mean increase in the lending rate, which attracts more foreign capital and therefore a rise in the rate of exchange between the currency and other currencies. Central banks can alter interest rates to put some pressure on the value of the country’s currency.

It is noteworthy that the relationship between interest rates and currency rates (when one rises the other also rises) is sometimes altered by inflation. Inflation can rise to a level that cause currency rates to reduce even when interest rates are rising.

4. Government Debt

Many countries use foreign debt (borrowed from outside the country) to finance public sector projects. Such debt is good for the country’s economic growth and development. However, large public debt can become a disincentive to foreign investors who might be interested in investing in the country. Debt servicing is also important to forex traders. Foreigners are less willing to invest in a country whose debt rating is going down because of failure of government to pay debt as per the terms. Reduced investment in a country by foreigners means decreasing demand for the country’s currency and thus its value goes down.

Large government debt can naturally encourage inflation. The government may print money and use it to pay off the debt but that increases money supply in the economy, which cause inflation to rise and currency value to deteriorate.

5. Political Stability

 

Political events affect a country’s economic outlook, and therefore the value of its currency. That’s why economic news almost always include political events. Forex traders follow political happenings to be able to gauge and predict the impact of these events on particular sectors, industry, or the economy as a whole.

Investors consider countries with less political risk as attractive investment destinations. Such countries receive large foreign investments, which leads to the appreciation of the domestic currency. A nation that is prone to political turmoil or where political uncertainty is experienced frequently is less likely to attract investors. This causes its currency to stagnate or depreciate over time.

While the above economic factors have great impact on Forex rates, some trading strategies consider other factors in Forex trading decision making. Today, many trading strategies make use of Elliott Wave Analysis to predict currency value movements. Elliott wave theory was introduced by Ralph Nelson Elliott in the 1930s. It proposes that prices of financial instruments result from the predominant psychology of investors. According to him, these prices move in recurring patterns (“waves”). These are the waves seen in financial markets, and which a trader should follow when making trading decisions.

Successful Forex trading involves closely following indicators of currency prices so as to make quick decisions whenever a profit-making opportunity is identified. If you are able to follow and analyse the above economic factors, then little is standing between you and big Forex trading profits.