In life, we fear that which we do not know. When it comes to foreign exchange rates, there is much to learn: they are influenced by the political, economic, and financial fortunes of the markets in which they operate. Knowing, and more importantly understanding, how these factors may influence the direction foreign exchange rates are moving can be key to preventing the costly error of trading currencies at the wrong time.
What Are the Key Economic Indicators Influencing Exchange Rates?
Understanding what factors affect an exchange rate can sometimes seem like a mysterious magic act. Exchange rates are nothing more than the price of a currency: just as you look at the price of a litre of petrol in Australian dollars when you pull into the petrol station, to see if it has gone up or down, you can look at the price of a foreign currency (in the form of an exchange rate) to see if that price has risen or fallen in Australian dollars. The price of a litre of petrol rises and falls in response to supply and demand, which is affected by factors in the world, such as international trade, which uses petroleum to power ships, trains, and airplanes. Political events can also make it difficult to export or import oil from certain countries, along with general economic news that affects the amount of petroleum used. In the same way, exchange rates are affected by key economic indicators, such as changes in capital markets, international trade, political events, and economic news.
The movements of capital markets in various countries are a broad indicator of potential changes in exchange rates. Changes in a country’s capital markets can influence the value of its currency, which is reflected in its exchange rate. A country’s debt and equity markets anticipate the changes to broader economic indicators within the country, as the value of the securities in the markets are based on the fortunes or failures of the companies in the country, which are in turn based on the health of their sales revenue.
International Trade Balances
Exchange rates often very closely follow the fortunes of a country’s international trade. A country’s international trade balances reflect the inflows and outflows of goods and services. When a country has a trade deficit, that country is a net importer of goods and services from other countries. Therefore, more of the local currency will be sold in order to pay for those goods and services, usually causing the currency’s exchange rate to trend lower. This is a reflection of basic supply and demand: more businesses and people in a country “give away” their currency in exchange for goods and services from foreign countries. As they give away their currency for foreign goods and services, this creates a surplus of their currency. This surplus acts on the exchange rate to push it lower. For example, after 28 consecutive months of trade deficits, Australia’s dollar (AUD) has fallen versus the U.S. dollar from rough parity in mid-2013 to about US$0.75 as of mid-November 2016.1,2
On the other hand, a trade surplus causes the exchange rate to increase: as foreign buyers seek to purchase the products and services being offered by the businesses in the country, those foreign buyers seek to purchase that country’s currency, increasing its scarcity and its price.
The policies a country’s government implements can have a significant effect on a currency’s exchange rate. As policies promote or suppress certain parts of a country’s economy, those changes can affect how desirable its currency is, in turn affecting the currency’s exchange rate. For example: a country implements policies which offer government subsidies, or lower tax rates, for an industry such as aircraft manufacturing. Foreign airlines purchase that country’s manufacturer’s aircraft, meaning those purchasers need that country’s currency. In Europe, for example, European governments paid for much of the research and development costs of the first Airbus aircraft and, even today, Airbus receives some subsidies.
Government policy also affects a currency’s exchange rate in other ways: elections, policy changes, and the balance of power of political parties can change the direction of a country’s economy. As the economy increases or decreases, so does the currency’s exchange rate. Central banks can also influence the currency’s exchange rate: as they adjust interest rates up and down, the exchange rate is also affected. A higher interest rate in a country can lead to the currency rising in value, as foreign investors seek to invest their money in the country’s debt, requiring that they purchase that country’s currency.
Economic releases, such as releases of statistical information by a country’s government agencies, also have an effect on exchange rates. Some of the most widely referenced economic releases (also referred to as economic indicators) are a country’s Gross Domestic Product (GDP), inflation rates, unemployment data, manufacturing indices, retail and consumer goods sales figures, new home construction figures, and lending data. Ideally, positive data generally will lead to a more desirable currency, leading to a higher exchange rate. This is not always true, as sometimes contradicting data can cause concerns of an impending imbalance in a country’s economy, with changes to the exchange rate following soon thereafter.
The monitoring of basic economic indicators supports companies in forecasting and intelligently planning currency transactions to take advantage of favourable currency exchange rates.
- Read the transcript – Leading Economic Indicators
The global nature of financial markets means political and economic events play a major role in influencing exchange rates.
The key areas of information to watch can be broadly categorised as capital markets, international trade, political events and economic news.
Performances in capital markets are important to track as they may influence the direction of a country's currency. It's often the case that equity and bond markets figure out what's happening before wider economic fortunes and currencies follow.
Next, you need to look at international trade balances.
A trade deficit means a country is a net importer of international goods and services, so more of the local currency will be sold to pay for goods and this generally leads the currency lower. And, all else equal, a trade surplus will push the currency higher.
Government policy is another big influencer of a country's economy, and therefore foreign exchange markets.
Elections, policy changes and the balance of power are all important to gauge currency direction.
Also wrapped up in politics are central banks. Any moves that may impact interest rates or exchange rates are to be watched closely.
Economic releases are the other key mover of exchange rates.
Gross Domestic Product is important, as are inflation and unemployment data, manufacturing indexes, retail sales, building approvals and lending levels. Preferably you're looking for leading indicators, but it all adds to the big picture so best stay across all key releases.
As to the important dates to watch out for, financial reporting seasons and large government debt issues are worth noting down, as are key data releases by the national statistics agency, government election terms and the central bank meetings.
By staying on top of market moving information, you can make rough forecasts and plan a proactive foreign exchange strategy that ensures you're not caught out trading at especially volatile times.
That said, an informed foreign exchange provider with a dedicated account manager will cover all these events and strategic implications for you.