Forex is a true global marketplace, with buyers and sellers from all corners of the globe participating in trillions of dollars of trades each day. 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. Below, we'll discuss some economic trends and events that will benefit those who are new to forex markets. (For background reading on forex, see "Popular Forex Currencies" and "How To Become A Successful Forex Trader.")
The Role of Macroeconomics in Forex
The forex market is primarily driven by overarching macroeconomic factors. These factors influence a trader's decisions and ultimately determine 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 events and information that may change on a daily basis, contributing to the 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.
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Capital Markets and Forex
The global capital markets are perhaps the most visible indicators of an economy's health, while stock and bond markets are the most noticeable markets in the world. It is difficult to miss the release of public information in capital markets, as there is a steady flow of media coverage and up-to-the-second information on the dealings of corporations, institutions and government entities. 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 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.")
The bond markets are similarly critical to what is happening in the forex market, since both fixed-income securities and currencies rely heavily on interest rates. Treasury price fluctuations factor in to movements in currencies, meaning that a change in yields will directly affect currency values. Therefore, it is important to understand how bonds — government bonds especially — are valued in order to excel as a forex trader.
International Trade and Forex
Another key factor is the 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 its value.
Trade surpluses and deficits also 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 the currency of other nations 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 Impact on Forex Markets
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.
For instance, 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. A good example is the Brexit vote, which had a major impact on the British pound (GBP) when the UK voted to leave the EU. The currency reached its lowest levels since 1985 after the vote because the UK's economical prospects were suddenly highly uncertain.
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 and Forex
Economic reports are the backbone of a forex trader's playbook. Maintaining an economic report calendar is crucial to staying current in this 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 of 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 retreating purchasing power. On the other hand, it can also lead to currency appreciation, as it may force central bankers to increase rates to curb rising inflation levels. Inflation is a hotly-contested issue among economists, and its effects on currencies are rarely straightforward.
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, serving as a suitable complement to the factors we've outline above.
The Bottom Line
The forex market is ultimately driven by economic factors that impact the value and strength of a nation's currency. 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 on the economic factors that specifically impact the U.S. dollar, see "Top Economic Factors That Depreciate the $US."