There are several fundamental factors that help shape the long-term strength or weakness of the major currencies and will affect you as a forex trader.
Economic Growth and Outlook
It’s easy to understand that when consumers perceive a strong economy.
Consumers feel happy and safe, and they spend money. Companies willingly take this money and say, “Hey, we’re making money! Wonderful! Now… uh, what do we do with all this money?” Companies with money spend money. And all this creates some healthy tax revenue for the government. They jump on board and also start spending money. Now, everybody is spending, and this tends to have a positive effect on the economy. Weak economies, on the other hand, are usually accompanied by consumers who aren’t spending and businesses who aren’t making any money and aren’t spending. Hence, the government is the only one still spending. But you get the idea.
Both positive and negative economic outlooks can directly affect the currency markets.
The most commonly used measure of economic growth is GDP.
GDP stands for “Gross Domestic Product” and represents the total monetary value of all final goods and services produced (and sold) within a country during a period of time (typically one year).
GDP provides an economic snapshot of a country, used to estimate the size of an economy and its growth rate.
Here’s a visualization that shows the $86 TRILLION global economy in one chart:
As you can see:
- The United States is still the world’s largest economy.
- China is the world’s second-largest economy.
- The United States and China comprise nearly 40% of the global economic GDP.
- The top 15 economies represent 75% of the total global GDP.
Globalization, technological advances, and the internet have all contributed to the ease of investing your money virtually anywhere in the world, regardless of where you call home. You’re only a few clicks of the mouse away (or a phone call for you folks living in the Jurassic era of the 2000s) from investing in the New York or London Stock Exchange, trading the Nikkei or Hang Seng index, or opening a forex account to trade U.S. dollars, euros, yen, and even exotic currencies. Capital flows measure the amount of money flowing into and out of a country or economy because of capital investment, purchasing, and selling.
With more investment entering a country, demand increases for its currency as foreign investors have to sell their currency to buy the local currency.
This demand causes the currency to increase in value.
Simple supply and demand.
And you guessed it: if supply is high for a currency (or demand is weak), the currency tends to lose value.
When foreign investments make an about-face, and domestic investors also want to switch teams and leave, you have abundant local currency as everybody is selling and buying the currency of whatever foreign country or economy they’re investing in.
Foreign capital is nothing more than a country with high-interest rates and strong economic growth. If a country also has a growing domestic financial market, even better!
A booming stock market, high-interest rates… What’s not to love?! Foreign investment comes streaming in.
And again, as demand for the local currency increases, so does its value.
Trade Flows and Trade Balance
Fundamental Factors affecting currency values in international trade can be broadly distinguished between goods (merchandise) and services trade. Most international trade concerns physical goods, while services account for a much lower share.
World trade in goods has increased dramatically over the last decade, from about $10 trillion in 2005 to more than $18.89 trillion in 2019.
We’re living in a global marketplace. Countries sell their goods to countries that want them (exporting) while also buying goods they want from other countries (importing).
Trade balance (or balance of trade or net exports) measures the ratio of exports to imports for a given economy.
It demonstrates the demand for that country’s goods and services and its currency.
A trade surplus exists if exports exceed imports and the trade balance is positive. A trade deficit exists if imports exceed exports and the trade balance is negative.
Exports > Imports = Trade Surplus = Positive (+) Trade Balance
Imports > Exports = Trade Deficit = Negative (-) Trade Balance
Trade deficits can push a currency price down compared to other currencies.
Net exporters, countries that export more than they import, see their currency being bought more by countries interested in buying the exported goods.
Trade surpluses tend to experience currency appreciation.
It is in more demand, helping their currency to gain value.
It’s all due to the DEMAND for the currency.
That’s because when exporters convert the foreign currencies they earn abroad into their domestic currency, this tends to put upward pressure on the domestic currency.
Currencies in higher demand tend to be valued higher than those in less demand.
The Government: Present and Future
After the Great Financial Crisis (GFC) caused the Great Recession during the late 2000s, all eyes were glaringly watching their respective countries’ governments, wondering about the financial difficulties being faced and hoping for some fiscal responsibility to end the woes felt in our wallets. A decade later, we face a similar situation as the world navigates a global health crisis and economic collapse caused by the coronavirus (COVID-19) pandemic. Instability in the current government or changes to the current administration can directly affect that country’s economy and even neighboring nations. And any impact on an economy will most likely affect exchange rates.