The foreign exchange or forex market is the biggest and most active financial market in the world. Every day, participants from all over the world engage in trillions worth of foreign exchange transactions. Events from all corners of the globe can have an immediate effect on exchange rates and currency values due to the global and inter-connectedness of the forex marketplace.
Below, we'll discuss a few typical global events that may influence the forex market.
TUTORIAL: Economic Indicators To Know
Political Impact on Currency Prices
A poltical election – a common event in almost every nation – can have a large impact on a country's currency. Elections can be viewed by traders as an isolated case of potential political instability and uncertainty, which typically equates to greater volatility in the value of a country's currency. In most situations, forex participants will simply keep an eye on pre-election polls to get a sense of what to expect and see if there will be any changes at the top. That's because a change in government can mean a change in ideology for the country's citizens, which usually equates to a different approach to monetary or fiscal policy, each serving as big drivers of a currency's value.
Additionally, political parties or individuals who are seen as more fiscally responsible or concerned with promoting economic growth tend to boost a currency's relative value. For instance, an incumbent who is seen as "pro economy" that is in danger of losing their position of power may lead to currency drops for fears of limited future economic growth and predictability.
Another circumstance of great importance is an unexpected election. Whether it comes via a non-confidence vote, corruption scandals or other situation, unplanned elections can wreak havoc on a currency. For example, cases of upheaval among citizens that result in protests or work stoppages can cause great uncertainty in countries and increased political instability. Even in cases where an autocratic government is being challenged in favor of a new, more democratic and economically open-minded government, forex traders don't like the uncertainty. Political instability has a tendency to outweigh any positive outcomes from a new government in the short run and related currencies will usually suffer losses.
However, basic valuation factors and principals will once again apply and currencies should settle at or around a rate indicative of the country's economic growth prospects over the long term. (For further reading on country-specific risk, see "Evaluating Country Risk for International Investing.")
Impact of Natural Disasters on Currency Prices
The fallout from a natural disaster can be catastrophic for a country. Earthquakes, floods, tornados and hurricanes harm a country's citizens, morale and infrastructure. Additionally, such disasters will also have a negative effect on a nation's currency. The loss of life, damage to major factories and distribution centers, coupled with the uncertainty that inevitably comes with natural disasters, are all bad news for a currency.
Infrastructure damage is also a key concern when it comes to the impact of natural disasters. The fact that basic infrastructure is the backbone of any economy, breaks in that infrastructure can severely limit the economic output of a region. Furthermore, the additional costs that are incurred to clean up and rebuild after a disaster takes away from government and private spending that could have been used towards economically advantageous ventures, rather than towards patching up a break in the value chain from damages in infrastructure.
Add to this a probable decrease in consumer spending due to the economic uncertainty and a possible loss of consumer confidence, and any economic strengths can be turned into economic weaknesses. In all, a natural disaster will almost surely negatively effect a nation's currency.
Effect of War on Currencies
Unlike a currency war, wherein countries actively attempt to devalue their currencies to aide their domestic economies in global export trading, a physical war can be far more devastating to a country's economy. Much like a natural disaster, the impact of war is brutal and widespread. Similar to disasters, the damage of war to infrastructure deals a huge blow to a nation's short-term economic viability, costing citizens and governments billions of dollars.
History has shown than war rebuilding efforts must often be financed with cheap capital resulting from lower interest rates, which inevitably decrease the value of a domestic currency. There is also a huge level of uncertainty surrounding such conflicts on future economic expectations and the health of affected nations. Thus, nations that are actively at war experience a higher level of currency volatility compared to those not engaged in conflict.
That said, some economists believe that there is potential economic upside to war. War can kick-start a fledgling economy, especially its manufacturing base, when its is forced to concentrate its efforts on war time production. For instance, the U.S. entry into World War II following the attacks on Pearl Harbor helped pull the country out of the grips of the Great Depression. While there is some historical precedent for this viewpoint, most would agree that an improved economy at the cost of human lives is a very poor trade-off. (To learn more about Germany's post-WWII economic rise, see "The German Economic Miracle.")
The Bottom Line
Political turmoil, natural disasters and war are just a few events that can have a profound effect on the currency markets. A great deal of a currency's value is derived from the economic strength of a nation, and any unforeseen uncertainty to future economic forecasts will typically not work in a currency's favor. While it is very difficult to plan for the unexpected in the forex market, an informed trader will use global events as a primary indicator within a comprehensive trading strategy.