There are three primary domestic drivers of currency and four main global drivers. Although the drivers are somewhat interrelated, yet they are unique and deserve discussion one by one. To understand how some of the factors interrelate, you can check out the figure below. From the image, you can get an idea of the interplay and relationships between domestic and global fundamentals.
The two types of Drivers for Currencies :
It is essential because of the influence on FX by the flow of money around the world. Global growth is a major driver of plenty of currencies. When it is strong, exporters like Brazil, China, and Korea tend to do well. Similarly, when it is weak, money tends to flow into safe haven currencies like CHF, JPY, and often the USD.
Commodity prices and terms of trade influence some currencies very strongly. Usually, global growth drive commodities but they also move because of other factors like supply and production, the popularity of commodities as an asset class, idiosyncratic demand factors, inflation and climate. Commodity exporters like Canada, Australia, and Brazil benefit from commodity price strength. Importers like India and Turkey, however, are hurt by high commodity prices. There are certain countries that export specific commodities and those commodities influence the currencies of those countries more than others. The more a country gets into exporting a certain commodity, the more the price of the commodity influences the currency.
Fluctuations in global risk appetite and risk aversion cause forex movements often regardless of the underlying domestic fundamentals of countries individually. You must know that every country has a different personality from the other and certain currencies are safe havens. When markets are nervous, traders usually flock to low yielding safe-haven currencies such as the CHF and JPY. We saw it in 2008 when the JPY, CHF, and a low yielder of that time USD exploded higher because of the global financial crisis.
Apart from influencing global risk appetite, geopolitics can also trigger certain currency movements in affected countries. If Russia goes through instability, then it will drive the selling of PLN, RUB, and TRY. For example, it can happen if the market attempts to avoid losses and reduces the regional risk in the process. Other sources of geopolitical volatility are elections, war, and major policy changes in regions or individual countries.
The domestic drivers
- Interest rates: Interest rates are the most important variable that drives forex markets most of the time and they are a product of central bank policy. Both the central bank rate and market-based interest rates are important for the currency. These rates are a product of market expectations for growth, inflation, and future central bank action and vary by time frame or tenor.
- Growth: Usually, growth is a good thing for a currency and a country. With higher growth, comes investment, and higher rates. Countries with high growth attract capital because they feature strong stock markets and higher interest rates. Outside investors need to purchase the currency to pay for their investments. For example, if Canada has strong growth, foreign investors will want to purchase Canadian equities. To do this, they will have to purchase Canadian dollars first. If you consider currency as the stock of a country, then growth pushes the stock higher, just like in private companies. Key metrics of growth include industrial production, housing statistics, GDP, and retail sales.
- Inflation: Inflation is more ambiguous. It can be either good or bad for a currency. Its impact on currencies is confusing, especially when it comes to emerging markets. You need to understand the current inflation regime for the currency you trade because the relation between forex and inflation is never simple. For example, rising inflation is good for a currency when the central bank of the country is credible and is willing to raise rates in response to inflation. Similarly, falling inflation is generally bad for developed nations’ currencies because it allows the central banks to cut rates, and lower interest means a lower currency usually. However, rising inflation is bad for a country if the central bank cannot respond fast with interest rate hikes. At the same time, deflation can be good if the central bank is not willing to act.
- Central bank preference for weak or strong currency: It is important if a central bank wants its currency stronger or weaker because central banks can influence the value of their currency directly or indirectly. They do it by lowering or raising interest rates. The other approaches are direct intervention and signaling.
Capital flows like foreign direct investment, equity and bond flow, and mergers and acquisitions (M&A) are important drivers of forex rates. A cross-border generates massive forex flows in many instances as the foreign company has to pay for the acquisition in the domestic company’s currency. M&A has an immediate and short-term impact on forex while portfolio rates can last for months or years. Investment flows are generally not the biggest driver of forex markets but when it comes to extended periods, they can have a meaningful influence. The problem of using capital flows as an input while trying to forecast forex is that capital flows are hard to predict. You can see flows as a post explanation for currency moves often, but it is not common to see predictions of forex forecasts on future capital flows.
Current account balance and trade balance are important in determining currency rates during the long run, but they have little influence during the short run. There are arguments that forex influences these drivers and not the other way around. These balances go in and out of vogue as forex drivers, but you cannot deny that global trade drives a large portion of cross-border forex flows.
The Bottom line
Note that all the fundamentals drivers have a high degree of interdependence among them. Each can influence others and often does so. Also, one main variable can drive all the others. So, when you analyse the drivers, try to figure out which one is driving the change and which ones are tagging along. After you understand how fundamental factors influence currency markets, you can move on to economic releases in currency trading.