Understanding how economic factors influence prices in the forex markets

There are plenty of macroeconomic theories that attempt to explain the behavior of forex trading in the long term but you need not really concern yourself with them. The very fact that there are so many theories would seem to indicate that economists themselves do not agree. It is, however, important that you are familiar with the economic data that moves the markets day by day and week by week. If you are familiar with stock markets, you will understand that economic data is to a country and its currency what earnings reports are to a company’s stock prices. News and information about the country has a decisive impact on the direction of the currency prices.

We describe below the factors and the data that are generally accepted as the most important influences on the price of a currency:

Interest rates: whether you talking about fundamental analysis or technical analysis, it is almost universally agreed that prices of currencies depend substantially on the differentials in interest rates. The interest rate benchmark that is generally used is the rate set by the central bank in question for that particular currency. These are generally plotted in a graph called a yield curve that plots the different rates against the different maturities (for instance, overnight, six months, one year, three years and so on). These rates provide us with some indication on what the market thinks of the central bank’s policies. The yield curve is also a reliable basis on which to predict economic cycles and future trends in interest rates. Considering the importance of interest rates in determining currency prices, this is a valuable tool for any forex trader.

Gross domestic product: Gross domestic product (GDP) is the total value all the goods and services produced by a country during a particular period. It is generally divided into four parts-consumer spending, business spending, government spending and net exports. GDP is generally regarded as the one figure that best measures the health of an economy and robust GDP growth reflects a healthy economy. This makes it attractive for foreigners to invest and will, over a period of time, make the currency more valuable. In the US, this figure is released every month by the Bureau of Economic Analysis.

Inflation: inflation is the measure of increases or decreases in the overall price level. Because of the immense number of goods and services, inflation is generally measured for a basket of goods and services that are considered to be representative of the economy as a whole. A high level of inflation almost always results in the depreciation of the currency in question. For the US, inflation data as reflected in the Consumer Price Index is announced on a monthly basis by the Bureau of Labor Statistics.

Balance of payments: International trade and capital flows can have a major impact on the prices of currencies. Trade flows measure the difference between the imports and exports and an excess of imports over exports is called a trade deficit. A country with a large trade deficit could see its currency depreciate as it sells more of its own currency to generate the currency required to finance imports. On the other hand, capital flows measure the movements of capital in and out of a country.  A country with a large inflow of capital because of foreign investment will have a surplus capital flow. The combination of trade and capital flows is referred to as the balance of payments of a country. A surplus balance of payments is likely to have a beneficial effect on the value of the currency.

Employment data: most countries release data periodically on the employment situation within the country. A marked increase in employment signals a healthy economy whereas a decline in employment could reflect potential problems ahead. The actual effect on currency prices will depend on the situation. For instance, when a country is emerging from an economic crisis, increased employment could signal the beginning of a recovery and the currency will appreciate. On the other hand, since a higher level of employment goes hand in hand with a higher rate of inflation, the currency could depreciate. In the US, employment data is released by the Bureau of Labor Statistics on the first Friday of every month and is a signal that is closely watched by the forex markets.

In addition to these factors, there are other economic and political factors such as wars, elections or financial crises that have profound implications for the forex markets. You only have to look at the recent economic crisis that shook the world but had its foundation in the relatively obscure subprime US housing markets. Witness also how the trouble that Greece is undergoing is taking its toll on the value of the Euro.

If all this sounds formidable, don’t let it intimidate you. Your native good sense combined with your judgment as well as advice from a good forex broker will quickly enable you to decide which are the important factors that influence the currency pairs that you choose to trade. You will quickly learn to interpret the economic data and to stay right on top of the forex markets.