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Undoubtedly, the currency market is the largest of all markets, if only for the fact that nearly all other financial markets are traded in currency. It is not surprising that so many are attracted to it and the huge opportunity that it presents for making a profit, but more important than trying to make a profit from this market is understanding what makes it tick.
The forex market and the currency pairs that are traded therein are influenced by the utterances of influential persons as well as geo-political and technical factors, not to mention economic realities. To understand the markets, you must first recognize that currency pairs really just represent the rate at which one country’s currency trades for the currency of another. Consequently, we can better understand what influences affect foreign exchange rates by seeking to understand how various market forces affect the economic fortunes of a country, among other factors.
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Central Bank and Government’s Economic Policy
Governments, and indeed central banks, have tremendous power to influence foreign exchange rates, simply because they have the power to make policy changes and affect systems that can drastically change rates. Therefore market players will listen keenly to what the finance ministers/treasury secretaries, prime ministers and central bank governors have to say on economic matters.
Market participants will be keen to see how the government and central bank manage inflation, money flow, economic growth and a host of other factors. Market observers are also aware that they can get some insight, and perhaps forecast upcoming policy changes by listening to and reviewing what these influential persons and institutions say in speeches, reports and official statements. Any material change in economic or political policies, whether perceived or actual, has incredible power to influence exchange rates.
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Fundamental Analysis, Technical Analysis and Speculators
Banks, governments, businesses and retail customers all trade currencies to satisfy their various needs. Governments do so to protect their country’s international reserves from currency fluctuations, so too do businesses that have international interests. On the other hand, banks may hold currency positions to settle transactions on behalf of their clients and in some cases may have a currency trading desks that has the sole objective of making a profit from the forex market.
However, currency speculators, retail and commercial customers can only cause large exchange rate moves in liquid markets if they trade large amounts, either individually or collectively. Even so, it is possible to move the market with low trade volumes if the market is illiquid (there aren’t many players in the market). In any case, it is important to remember that low volumes in the $3 trillion a day forex market can still be huge.
Many market players make trading decisions based on fundamental analysis. For example, high inflation often suggests that the central bank may need to raise interest rates to cool or temper inflation. Higher interest rates on a particular currency will generally make it more attractive to investors, who can realize higher returns from holding positions in higher yielding currency pairs. This is more so the case when inflation is spurred by positive economic activity as opposed to bad economic management.
Because the release of economic data is generally scheduled, it is possible to know exactly when the market will move based on when new economic data will be released. All the trader is left to do is figure out in what direction to place the trade. You can find a schedule of economic releases by using and economic calendar. If you use a good economic calendar it should tell what news releases have a high, medium or low chance of moving the market. Some economic releases to pay attention to include:
- Interest rate decisions
- Foreign purchases of U.S. Treasuries (TIC data)
- Trade balance
- Current account
- Durable goods
- Retail sales
- Inflation (consumer price index)
- Gross domestic product
On the other side of the equation, trading decisions are often made based on technical analysis. In essence, trades are taken based on whether trading charts suggest that a currency pair is going to fall or rise. Technical analysis may look at such things as candlestick patterns and support and resistance levels of a 100 periods moving average line. There are also scores of technical indicators that are used by traders; the more traders there are that use these indicators, the greater the chance that they will influence price movements when certain values are hit. Some popular technical indicators include the RSI, Fibonacci tool and CCI indicators.
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Geo-Political Events: Perceived and Actual
No country is an island; the events in one country can very well affect the economic fortunes in a neighboring, or even far-flung country. Take for instance the impact that political unrest in the Middle East had on oil prices in early 2011. While there were many other forces at play, the fact that so many countries rely on oil to fuel their economies meant that those unrests made oil prices higher. As a result of rising oil prices, the economic competitiveness of oil dependent economies fell, no doubt putting some currencies under pressure.
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What It Takes to Move Forex Rates
Sometimes a glance at the financial news or economic calendar can easily reveal what is causing exchange rates to move, but in other cases it won’t be that easy. The truth is that the market is always pricing currencies. With each player entering and closing trades based on his or her market analysis and information, it is not possible to explain every little price blip, but a reasonable explanation can usually be found for larger moves.
Being a very liquid market, it usually takes large volumes to move exchange rates, which is not to say that the collective trades of many market participants can’t simultaneously move the market. In fact, in the panic that unfolds during an economic meltdown or market crash, fear and greed on the part of a large number of traders can cause price movements to become volatile.
For more tips and strategies, be sure to check out the other items in Bright Hub's Collection of Forex Trading Guides.
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Chen, James. “Essentials of Foreign Exchange Trading.” John Wiley and Sons, 2009: 15
“Fundamentals - What Moves the Currency Markets,” http://www.fxstreet.com/education/forex-basics/10-basisc-forex-lessons/2010/05/10/