5 factors that cause currency price movements explained simply
If you are the sort of person who pays a lot of attention to financial and economic news, then you will often hear about movements in the value of currencies. Recently the strength of the dollar and the weakness of the euro have been prominent stories in the world of currencies and many investors try to take advantage of these currency moves by trading in what is known as the forex market. But why do currencies move and fluctuate in value? There are many reasons why a currency might lose or gain in value against another but let’s consider some common factors, or ones that have been causing some of the recent currency price movements we’ve seen.
As with all things financial, there are much more complex explanations for each of the following factors we are about to mention but the aim of this post is not to delve too deep into each one but rather to try and keep things as simple as possible. We should also mention that the following statements are general rules and may not always work out to be true depending on what overall economic conditions are present in, or are affecting any given country or currency.
The inflation rate of a country compared to that of another is one factor which can cause a currency to weaken or to gain in strength compared to its counterpart. When a country is experiencing high inflation, the value of the currency will usually weaken. In turn, a country that is experiencing low inflation may see its currency rise in value compared to its counterparts. For a more in-depth explanation of how inflation can affect exchange rates, see here.
Benchmark interest rates set by central banks are also likely to have an effect on the value of a currency. If interest rates rise in a country then the value of the affected currency tends to rise too because the lure of higher returns should entice foreign investment into the country. If interest rates are rising to control a rapidly rising inflation rate however then the high inflation rate might put investors off, as mentioned in the previous paragraph. Recent dollar strength is one example of how a currency can rise in expectation of higher interest rates.
The Economic Performance of a Country
If a country is showing signs of strong economic performance then this could cause its currency to gain in value as this strong economic performance should again lead to more foreign investment. On the opposite side of the coin, if a country is experiencing weak economic performance then investors may pull money out of the country and head elsewhere with the hope of getting a better and more stable return.
The effect of money supply on the value of currencies has been much discussed in recent years as many countries have embarked on programs of quantitative easing, or money printing to you and me. When the central bank of a country or economic area prints money, it effectively reduces the purchasing power of the money that is already in existence, which then increases the likelihood of inflation. When this happens the currency should, in theory, weaken when compared to its counterparts. As we said in the introduction to this post though, financial markets do not always react as you would expect them to and this is also true in forex markets.
General and Political Stability
It is generally accepted that for a country to perform well economically, it needs a strong and stable government. This will in turn attract foreign investors into the country as they will feel that their investment is safe and is not likely to have its value collapse overnight if the country were to experience some sudden political shock.
Looking at the Overall Picture
Here we have mentioned just 5 of the many factors that can cause currency valuations to fluctuate against one another and can therefore affect the success of your endeavours to make gains when trading in forex. The factors mentioned above should not be viewed as hard and fast rules but more as general guidelines. It is important to look at the overall picture of what is happening in a country as well as in other countries around the world when trying to predict future currency price movements, and not just to look at one single factor which might be affecting a given country.