Basic Explanation of Economic Drivers Behind the Forex Market
The economic factors that drive movements in the forex markets are actually quite straight forward to understand. This understanding is essential if you want to trade the forex market successfully.
Firstly, one has to understand the key difference between the forex market and the equities market where most small individual investors tend to invest. In the equities market, one invests in a particular company's stock. If that company is expected to perform well in the future, then its stock price will go up and vice versa. The equities market however is highly susceptible to general economic downturn, as in such an environment, expectations about most companies future performance are revised downwards and hence their stock prices go down.
On the other hand, the forex market is not directly influenced by economic downturns like a recession. This is because unlike the equities market, the forex market trades pairs of two countries' currencies. So, in simple terms, if one currency is losing value, then invariably the other currency is gaining value. This means that an investor can make money trading forex even in the worst of recessions. Of course, he or she needs to understand the economic factors that will make one currency more valuable than its counterpart.
The first factor is the comparative economic performance of the country. Say, you are trading the currency pair USD/GBP. Put very simply, if the US is expected to perform better than the UK or put another way, if the UK is expected to have a worse recession than the US, then the USD will appreciate compared to the GBP. This makes sense, because it means that the expectation is that investors would rather invest in the US than the UK as the US economy has a better prospect than the UK. As investors move their funds from UK investments to US based ones, they increase the demand for USD and at the same time are selling GBP as they leave that market. The forces of demand and supply in the global forex market then means that the value of USD goes up whilst that of the GBP goes down.
Now to go into a bit more technical detail. Interest rates are the most important drivers of forex movements. This is because interest rates are the most accurate indicator of a country's economic health. Governments use interest rates as the main lever at their disposal to steer their countries' economies. For instance, if a country is in a recessionary climate, then to stimulate demand and spending, government will reduce interest rates to allow people and companies to borrow money more cheaply and hence stimulate spending in the economy. This increased level of spending has a positive ripple effect as somebody's spending is another person's income and in turn that person has more income to spend and so on. This is called the multiplier effect. Conversely, if the economy is expanding too fast and there is a risk of inflation, then interest rates are raised to curtail spending and to encourage more savings instead in order to put the brakes on the economy expanding too fast.
So, to recap, governments use interest rates to steer the economy. This is part of a country's monetary policy. As interest rates are raised to encourage savings and reduce spending in an economy, foreign investors view that country more attractive to invest in as they can get a higher rate of interest compared to another country. So, they will move their investments from a lower interest rate country to a country where interest rates are higher in comparison.
In order to move their money from say country A to country B, they need to buy currency B and in turn sell currency A. So as the forces of demand and supply work their ways in the forex market, currency B will appreciate compared to currency A. So, in short, the currency of a country with higher interest rate will be stronger than that of a country with comparatively lower interest rates, as investors move their money from A to B to take advantage of the better rate of interests for their investments.
In addition to the current rate of interests, expectation of future interest rates of a country also have a very powerful impact on the value of that country's currency. This is because if investors expect interest rate to fall, they will move their investments to another country and hence immediately cause the currency to be sold in large volumes and hence drop in value. That is why a government's fiscal policies like raising/lowering of taxes and government national debt can also influence a currency value.
Hopefully this very high level explanation of the economic drivers of forex market movements has proved informative to any person looking to learn about trading the forex market as a small investor.