Economic Factors That Affect The Forex Market

By Investopedia Staff AAA

With buyers and sellers from all corners of the globe participating in trillions of dollars of trades each and every day, the forex market is a true global marketplace. The fact that foreign exchange trading has become such a globalized activity means that macroeconomic events play an even greater role in forex than ever before. Here we will discuss some economic trends and events that those new to forex should be aware of. (For more information, check out our Guide To Forex Currencies.)
TUTORIAL: The Most Important Forex Trading Rules

The Role of Macroeconomics in Forex
The forex market is primarily driven by overarching macroeconomic factors that influence the decisions of the traders who ultimately decide the value of a currency at any given point in time. The economic health of a nation's economy is an important factor in the value of its currency. Overall economic health, however, is shaped by numerous economic events and information that may change on a daily basis, contributing to the (nearly) 24/7 nature of the international foreign exchange market. Let's take a closer look at some of the factors that influence an economy's standing and drive changes in the value of its currency.

Capital Markets
The global capital markets are perhaps the most visible indicators of an economy's health. Stock and bond markets are the most noticeable markets in the world. With constant media coverage and up-to-the-second information on the dealings of corporations, institutions and government entities, there is not much public information that the capital markets miss. A wide rally or sell-off of securities originating from one country or another should be a clear signal that the future outlook (short term or long term) for that economy has changed in investors' eyes.

Similarly, many economies are sector driven, such as Canada's heavily commodity-based market. In this case, the Canadian dollar is heavily correlated to the movements of commodities such as crude oil and metals. A rally in oil prices would likely lead to the appreciation of the loonie relative to other currencies. Commodity traders, like forex traders, rely heavily on economic data for their trades, so in many cases, the same economic data will have a direct affect on both markets. (For more on this correlation, see How To Trade Currency And Commodity Correlations.)

Moreover, the bond markets are critical to what is happening in the forex market, since both fixed income securities and currencies are rely heavily on interest rates. Movements in Treasuries are a first level factor in movements in currencies, meaning that a change in yields will directly affect currency values. Because of how closely tied the two markets are, it is important to understand how bonds - and government bonds especially - are valued in order to excel as a forex trader.

International Trade
Another key factor is balance of trade levels and trends between nations. The trade levels between nations serve as a proxy for the relative demand of goods from a nation. A nation with goods or services that are in high demand internationally will typically see an appreciation of its currency. For example, in order to purchase goods from Australia, buyers must convert their currency into Australian dollars (AUD) to make the purchase. The increased demand for the AUD will put upward pressure on it.

Trade surpluses and deficits exemplify a nation's competitive standing in international trade. Countries with a large trade deficit are net buyers/importers of international goods, resulting in more of their currency being sold to purchase other nations' currencies in order to pay for the international goods. This type of situation is likely to have a negative impact on the value of an importing country's currency.

Political Conditions
The political landscape of a nation plays a major role in the economic outlook for that country and, consequently, the perceived value of its currency. Forex traders are constantly monitoring political news and events to gauge what moves, if any, a country's government may take in the economy. These can include measures from increasing government spending to tightening restrictions on a particular sector or industry.

An upcoming election is always a major event for currency markets, as exchange rates will often react more favorably to parties with fiscally responsible platforms and governments willing to pursue economic growth.

The fiscal and monetary policies of any government are the most important factors in its economic decision making. Central bank decisions that impact interest rates are keenly watched by the forex market for any changes in key rates or future outlooks. (For a closer look into monetary policy, see How The U.S. Government Formulates Monetary Policy.)

Economic Releases
Economic reports are the backbone of a forex trader's playbook. Maintaining an economic report calendar is crucial to staying current in this ultra-fast paced marketplace. GDP may be the most obvious economic report, as it is the baseline of a country's economic performance and strength. GDP measures the total output of goods and services produced within an economy. One key thing to remember, however, is that GDP is a lagging indicator, meaning that it reports on events and trends that have already occurred.

Inflation is also a very important indicator as it sends a signal as to increasing price levels and falling purchasing power. However, inflation is a double-edged sword, as many view it as placing downward pressure on a currency due to the retreating purchasing power. On the other hand, it can also lead to currency appreciation as it may force central bankers to increase rates in order to curb rising inflation levels. Inflation is a hotly contested issue amongst economists and its effects on currencies is never black and white.

Other reports such as employment levels, retail sales, manufacturing indexes and capacity utilization also carry important information on the current and forecasted strength of an economy and its currency.

Bottom Line
The biggest thing that should be taken from this article is that the forex market is ultimately driven by economic factors that, in turn, are indicators of a country's economic strength. The economic outlook for a country is the most important determinant of its currency's value, so knowing the factors and indicators to watch will help you keep pace in the competitive and fast-moving world of forex. (For additional reading, take a look at How To Become A Successful Forex Trader.)

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