Speculation with Forex Is A Lesser Part of the Picture
In a real sense, the equities market is purely driven by speculation, meaning that the desire to hold these securities to make money is what drives the entire market for them. So in looking at market behavior there is going to be some pretty strong correlations with that and where we may expect the price to move to, by just looking at the supply and demand side of things that is.
Now this isn’t to suggest that business results don’t matter, they certainly do, but more in the longer term. In the very short term, historical trading data is going to be most influential, the only thing that you want to be looking at really, and the longer the timeframe is, the less predictable market data alone will become, and the more important fundamentals will be.
To know where something is going to trade at in the next hour, you could get a pretty good idea just looking at where it is moving by way of charts, but 5 or 10 years down the road, this is going to really depend on where the business is headed primarily, in addition to where the market may be headed based upon overall business conditions.
With forex trading though, most of the trading with currencies is not speculative at all, and is driven by what we could call the fundamental demand for the currencies in a currency pair, relative to one another.
This is the main reason why fundamentals play a bigger role with forex trading, because the fundamentals itself will drive the market to a large degree at a fundamental level rather than a speculative one. It’s not that people want to hold USD for instance more than they want to hold EUR, it’s that more EUR may be converted to USD for a number of other reasons, and we may expect that to continue or increase based upon economic factors.
So there are several things that we can look at to decide where this baseline differential in demand may be headed, all which involve measuring the health of economies and deciding where the demand can be expected to be in a given time frame.
Inflation Plays a Huge Role in Currency Valuation
Forex trading is just looking to trade on the relative future values of currency, and although the trading that individual investors do in the forex market is always based upon spot prices, we’re actually trading on the future prospects of currencies, even though the time frame may be a short one.
Differentials in inflation will therefore influence the relative value of a currency pair, if for instance one may be expected to be devalued over time at a certain rate, and another is seen as being likely to devalue less, this is going to affect the comparison.
It’s not hard to understand why inflation data matters a lot to forex trading, and when a currency is expected to experience more inflation than another, that in itself will cause it to lose value against a less inflationary currency.
This is also why currency traders pay a lot of attention to interest rates, and why currencies lose value when they lower interest rates. It’s not even whether their interest rates were too high or are too low now, the current state is going to be priced into the market already a lot with the spot market, but as this changes and a country lowers their rates, or raises them, and the other currency does not, this will influence their relative expected inflationary pressures and affect their valuation.
Tinkering with inflation rates is a major tool used by central banks to influence the value of their currency relative to other currencies, and this does happen a fair bit, so looking at central banks and what they may do influences currency rates quite a bit. Just a mere statement by a central bank can drive the forex market, even though what they have to say may not be clear, and market participants will make their best efforts to decipher these messages and react accordingly.
Following The Money
Another factor that influences forex markets significantly is data that suggests changes in the flow of money in and out of a currency. This one is also pretty easy to understand, once you realize that the main reason why currency is exchanged is to pay for goods bought in a different currency, so more of that is going to result in a movement of money from one currency to another.
If for instance a country’s balance of payments changes, let’s say that the U.S. trade deficit increases, then more U.S. dollars will be sent out of the country and exchanged for other currencies. Since currency markets are measures of supply and demand, the net effect of this is that there will be more U.S. dollars sold in the market to buy other currencies, and this is going to reduce the currency’s value by creating more downward pressure on price.
What drives currency markets is external supply and demand of course, and while seeing a currency be expected to lose or gain value relative to each other will affect market behavior such that it may be more or less in demand, it all comes down to money flowing in or out of a currency, and changes in balance of payments are ultimately what decide this.
This is influenced by more than just a country’s imports and exports though, the amount of goods and services that goes in and out of a country. Prices of these imports and exports, and changes in these prices, does affect the inflow and outflow of currency as well.
As an example, if a country exports oil, and the price of oil goes up, then they may not be exporting any more, but the money they receive back will be greater, and this will change the amount of wealth transferred from one country to another, from one currency to another.
This is called changes in balance of terms, and as with net trade, we need to look at changes in net balance of terms, how the price of exports has changed relative to the price of imports in a country, with the net change being the one that matters.
Other Factors Influencing Currency Prices
The overall performance of governments, and especially changes in the level of borrowing of a government, influences currency markets, and can influence them quite a bit. This is especially the case when there is perceived instability with a country, which can be either economic or political.
Increases in government borrowing not only tends to devalue their currency thorough its increasing their inflation rate, borrowing from people in other countries will also tend to decrease the borrowing government’s currency as well.
To the extent that people are scared away from a given currency, this will of course change the demand for it.
A country’s overall business conditions can also matter a lot, as weaker economies relative to each other means that there is likely to be less demand for a currency of a country that is struggling more economically, which will lower its relative price.
In times of economic uncertainty, people may naturally favor one currency over another due to perceptions of stability, for instance by moving money to USD, which is seen by many to be seen as more stable than many other currencies. This can increase the demand for the currency by itself.
On top of all this, speculation does drive forex markets as well, although speculation represents a minority of forex transactions and therefore has less effect on these markets than you see in equity markets for instance.
This all might seem daunting, with so much to consider with trading forex, the market behavior, plus all this fundamental data, but it’s not hard at all to decide if certain fundamental data will hurt or help and interpreting this data is actually quite a bit easier than it is with individual companies.
There is still a fair bit to learn if one wants to become a successful forex trader but it’s nowhere near as complicated to master as it may initially appear.