What affects exchange rates: Top factors explained

What affects exchange rates? This seemingly simple question unveils a complex web of factors that can send currencies soaring or plummeting in the blink of an eye.

From macroeconomic indicators to geopolitical events, the forces influencing currency values are diverse and often intertwined.

According to the Bank for International Settlements, the daily trading volume in the foreign exchange market reached a staggering $7.5 trillion in 2022, highlighting the immense scale and importance of currency exchanges in the global financial system.

As businesses and investors navigate this volatile landscape, understanding the key factors affecting foreign exchange rate becomes crucial for making informed decisions and managing financial risks in international trade.

In this comprehensive guide, we'll delve into the multifaceted world of foreign exchange, exploring the causes for its volatility and their far-reaching impact on the global economy. 

Whether you're a seasoned trader, an international business owner, or simply curious about the mechanics of global finance, this article will provide valuable insights into the forces shaping the value of money across borders.

What affects foreign exchange rates?

1. Economy indicators

When it comes to understanding what affects exchange rates, economic indicators serve as the foundation for currency valuation.

These metrics provide crucial insights into a country's economic health and future prospects, directly impacting the demand for its currency.

Interest rates: the prime mover of currency values

Among the various factors affecting foreign exchange rates, interest rates stand out as one of the most significant.

Central banks use interest rates as a powerful tool to manage inflation, stimulate growth, and maintain economic stability.

When a country raises its interest rates, it typically leads to an appreciation of its currency. 

Why? 

Higher interest rates offer more attractive returns on investments denominated in that currency, drawing in foreign capital and increasing demand for the currency.

For example, if the U.S. Federal Reserve raises interest rates while other major economies maintain lower rates, the U.S. dollar is likely to strengthen against other currencies.

This relationship between interest rates and exchange rates is closely watched by forex traders and international investors alike.

However, it's important to note that the impact of interest rates on exchange rates isn't always straightforward. Market expectations and other economic factors can sometimes counteract or amplify the effects of interest rate changes.

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Don’t let foreign exchange volatility slow down your progress. Read: Mastering interest rates & borrowing costs for SME success.

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Inflation: the silent currency eroder

Inflation is another critical factor in the exchange rate equation. 

Generally, countries with lower rates tend to see their currencies appreciate relative to those with higher ones. This is because high inflation erodes the purchasing power of a currency over time, making it less attractive to hold or invest in.

The relationship between inflation and exchange rates is often described through the concept of purchasing power parity (PPP). 

According to PPP theory, exchange rates should adjust to equalize the purchasing power of different currencies over the long term. 

While PPP doesn't hold perfectly in the real world due to various factors, it provides a useful framework for understanding the long-term impact of inflation on currency values.

Consider the case of Turkey, which has experienced high inflation rates in recent years.

The Turkish lira has significantly depreciated against major currencies like the U.S. dollar and euro, partly due to the erosion of its purchasing power through inflation.

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Now that you’re getting a good grasp on what affects exchange rates, we recommend that you read this: The impact of inflation on SMBs - everything you need to know.

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GDP growth: a measure of economic health

Gross Domestic Product (GDP) growth is a key indicator of a country's economic performance and can have a substantial impact on exchange rates. 

Strong economic growth typically leads to an appreciation of a country's currency, as it signals increased productivity, higher employment, and potentially higher interest rates in the future.

Conversely, sluggish GDP growth or economic contraction can lead to currency depreciation.

Investors and traders often view robust GDP growth as a sign of economic strength, which can increase demand for a country's currency and drive up its value relative to other currencies.

For instance, during the COVID-19 pandemic, countries that managed to maintain positive GDP growth or recover more quickly, such as China, saw their currencies perform relatively well against those of more severely affected economies.

2. Political stability and geopolitical events

While economic indicators provide a foundation for exchange rate movements, political factors can often cause sudden and dramatic shifts in currency values.

Political stability and geopolitical events are among the most unpredictable factors affecting foreign exchange rates.

Political stability: a currency's bedrock

A country's political environment plays a crucial role in determining the stability and attractiveness of its currency. 

Nations with stable political systems, strong institutions, and predictable policy-making tend to have stronger and more stable currencies. 

This is because political solidness fosters economic certainty, encourages foreign investment, and promotes long-term economic growth.

On the other hand, political instability can lead to rapid currency depreciation. 

Events such as coups, civil unrest, or significant policy shifts can shake investor confidence and trigger capital flight, putting downward pressure on the local currency.

A prime example of this is the impact of Brexit on the British pound.

The uncertainty surrounding the UK's decision to leave the European Union led to significant volatility in the pound's value, with sharp declines following key Brexit-related events.

Geopolitical events:shockwaves in the forex market

Geopolitical events, ranging from trade disputes to military conflicts, can have far-reaching effects on exchange rates. These situations can alter the perceived risk associated with holding certain currencies and lead to rapid shifts in forex markets.

For instance, the ongoing trade tensions between the United States and China have periodically impacted the exchange rates of both the U.S. dollar and the Chinese yuan.

Announcements of new tariffs or trade negotiations often result in immediate currency market reactions.

Similarly, global crises such as the COVID-19 pandemic can dramatically reshape the forex landscape.

During the early stages of the pandemic, we saw a flight to safety, with investors favoring currencies perceived as safe havens, such as the U.S. dollar and Swiss franc.

3. Market sentiment: the psychological aspect of exchange rates

While economic fundamentals and political factors provide a basis for exchange rate movements, market sentiment and speculation can often drive short-term fluctuations. 

Understanding these psychological aspects is crucial for grasping why currency rates fluctuate on a day-to-day basis.

Market sentiment: the collective mood of traders

Market sentiment refers to the overall attitude of investors toward a particular currency or the forex market as a whole.

It can be influenced by a wide range of factors, including economic data releases, political statements, or even rumors and speculation.

Positive sentiment towards a currency can lead to appreciation, as more traders and investors seek to buy that currency. 

Conversely, negative feelings can result in depreciation as market participants sell or avoid the currency.

For example, optimistic economic forecasts or positive political developments can boost sentiment towards a country's currency, potentially driving up its value even before concrete economic changes materialize.

Speculation and foreign exchange volatility

Speculation plays a significant role in the forex market, often amplifying price movements and contributing to foreign exchange volatility.

Currency traders and speculators attempt to profit from short-term price movements, sometimes based on anticipated future events or technical analysis rather than current economic fundamentals.

Large speculative positions can sometimes lead to self-fulfilling prophecies in the short term. 

If enough traders believe a currency will appreciate and act on that belief by buying it, their collective action can indeed drive up the currency's value, at least temporarily.

However, it's important to note that while speculation can cause short-term fluctuations, long-term exchange rate trends tend to align more closely with economic fundamentals.

4. Government debt and current account balance

If you’re wondering what affects foreign exchange rates, think about a country's financial health. 

Its “well-being” is reflected in the government debt levels and current account balance, which can significantly influence its exchange rates.

These factors provide insights into a nation's economic sustainability and its reliance on foreign capital.

Government debt: the long-term currency burden

High levels of government debt can put downward pressure on a country's currency in the long term.

This is because excessive debt raises concerns about the government's ability to meet its financial obligations and may lead to inflation if the debt is monetized (i.e., if new money is created to pay off the debt).

Investors often view high government debt levels as a risk factor, potentially leading to reduced demand for the country's currency and assets denominated in that currency.

This can result in currency depreciation over time.

For instance, concerns about high debt levels in some Eurozone countries during the European debt crisis led to periods of weakness for the euro against other major currencies.

Current account balance: the trade factor

A country's current account balance, which primarily reflects its trade balance (exports minus imports), can have a significant impact on exchange rates.

A current account surplus typically supports a stronger currency, while a deficit can lead to depreciation.

Countries with current account surpluses are net exporters, meaning they receive more foreign currency from their exports than they spend on imports.

This inflow of foreign currency can increase demand for the domestic currency, leading to appreciation.

Conversely, countries with current account deficits need to finance their excess imports by borrowing or selling assets to foreigners, which can put downward pressure on their currency.

For example, countries like Germany and Japan, which have consistently run current account surpluses, have often seen their currencies strengthen over time. 

On the other hand, the United States, which has run persistent current account deficits, has experienced periods of dollar weakness, although this effect is somewhat mitigated by the dollar's status as the world's primary reserve currency.

5. Technological advancements and forex markets

In recent years, technological advancements have significantly impacted how exchange rates are determined and traded. 

The rise of algorithmic trading, big data analytics, and blockchain technology has transformed the forex landscape.

Algorithmic trading: speed and efficiency in forex

Algorithmic trading, or algo-trading, uses complex mathematical models and high-speed computer programs to execute large volumes of trades in fractions of a second.

This technology has increased market efficiency and liquidity but has also introduced new dynamics to exchange rate movements.

Algo-trading can lead to rapid price adjustments as new information enters the market. 

It can also amplify trends and potentially increase short-term volatility, especially during periods of market stress or when unexpected events occur.

Big data and predictive analytics

The advent of big data and advanced analytics has provided traders and investors with new tools to analyze and predict exchange rate movements. 

By processing vast amounts of data from various sources - including economic indicators, social media sentiment, and news feeds - these technologies aim to identify patterns and trends that might influence currency values.

While these tools have enhanced the sophistication of forex analysis, they have also increased the complexity of factors affecting exchange rates.

The integration of machine learning and artificial intelligence in forex trading continues to evolve, potentially reshaping how currency values are determined in the future.

Why do currency rates fluctuate?

Ever wondered why your holiday money seems to shrink or grow overnight? Or why your international business deals can suddenly become more lucrative or costly? 

Welcome to the wild world of currency fluctuations.

Let's break down the reasons behind these financial mood swings in a way that won't make your head spin.

1. Supply and demand

At its core, currency fluctuation is all about supply and demand - just like that overpriced vintage t-shirt you've been eyeing online. 

When more people want a currency (high demand) or there's less of it available (low supply), its value goes up. And vice versa.

But here's the kicker: unlike that t-shirt, currency demand isn't just about looking cool. It's driven by a complex web of factors, from interest rates to political stability. Speaking of which…

Before digging deeper on what affects exchange rates, recap some of the basics: How supply chain finance works: all you need to know.

2. Interest rates

Picture this: you're at a party (stay with me here), and someone's offering free pizza in one room, while another's charging for stale crackers. 

Where's everyone going to flock?

That's right, free pizza central.

Now, replace "free pizza" with "higher interest rates," and you've got the forex market in a nutshell. 

When a country raises its interest rates, it's like they're offering a better deal on their currency. Investors rush in, demand goes up, and voilà - the currency strengthens.

3. Economic performance

Currencies are a bit like high school - everyone wants to hang with the cool kids. In this case, the "cool kids" are countries with strong economies. 

Robust GDP growth, low unemployment, and stable inflation make a currency more attractive. It's like the economic equivalent of having a nice leather jacket and a motorcycle.

But beware: economic indicators can be fickle friends. One bad report can send a currency tumbling faster than you can say "recession."

4. Political climate

Remember how the stock market freaked out every time a certain world leader tweeted? 

That's because politics and currencies are more intertwined than your earphones after a day in your pocket.

Political stability breeds confidence, and confidence attracts investment. 

But throw in some political drama - an unexpected election result, a corruption scandal, or geopolitical tensions - and watch the currency markets go into a tizzy.

5. Speculation

Here's where things get a bit wild. Some currency movements aren't based on what's happening now, but on what people think might happen in the future. It's like betting on the weather - sometimes you're spot on, sometimes you're caught in a downpour without an umbrella.

Forex traders and investors often make moves based on their predictions of future events. 

If enough people believe a currency will strengthen and buy it, that very action can cause it to strengthen. It's a self-fulfilling prophecy, forex style.

6. Global events

In our interconnected world, a sneeze in one country can cause a financial flu in another. Global events - from natural disasters to pandemics (looking at you, COVID-19) - can send shockwaves through currency markets.

These events can disrupt trade, shake investor confidence, and force governments to take drastic economic measures. 

The result? 

Currency values that bounce around like a pinball in a particularly vigorous game.

You’re learning what affects exchange rates, but still fears to be blindsided by unexpected events? Take a look at this Ted Talk, where Didier Sornette, a risk economist share some insights:

Understanding why currency rates fluctuate is like trying to predict the plot twists in a complex TV series - there are many moving parts, and sometimes the writers (or in this case, the market forces) throw in a surprise just to keep you on your toes.

But armed with this knowledge, you're better equipped to navigate the thrilling, sometimes maddening world of forex. 

Just remember: in the currency game, the only constant is change.

Inflation vs exchange rates: the financial tango

Picture inflation and exchange rates as dance partners in the grand ballroom of economics. They're locked in a complex tango, each influencing the other's moves in a delicate balance of cause and effect.

Here's the deal: inflation is like a sneaky thief, slowly pilfering your currency's purchasing power.

As prices rise, each unit of your currency buys less stuff. 

Now, imagine you're a foreign investor eyeing this inflating currency.

Suddenly, it looks about as appealing as a melting ice cream cone on a hot day.

This is where exchange rates step in. 

As inflation rises, the demand for that currency often falls faster than a skydiver without a parachute. 

The result? 

The currency's value drops relative to other, more stable currencies. It's like watching your favorite sports team slide down the league table – painful, but sometimes inevitable.

But wait, there's a plot twist! Some central banks try to combat high inflation by hiking interest rates.

‍Higher rates can attract foreign investment, potentially strengthening the currency. It's like offering free popcorn at the movies – suddenly, everyone wants in.

However, if inflation outpaces interest rates, you're still in hot water. 

The bottom line? 

Inflation vs exchange rates is an eternal dance, each influencing the other in a never-ending cycle.

So next time you see inflation rising, keep an eye on those exchange rates – they might just be gearing up for their next move.

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Overcome the impact of exchange rates with Stenn

That’s a wrap! You now know what affects foreign exchange rates and what types of risks it represents to international trade.

As you’ve seen, the underlining actors are numerous and interconnected. 

From macroeconomic indicators like interest rates and inflation to political stability, market sentiment, and technological advancements, a wide array of forces shape the value of currencies in the global marketplace.

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