All markets move on supply and demand; the forex market is no different. When a currency pair is being traded at a high volume, the price of the currency being bought will increase in value because it is sought after, i.e., there are more people wanting to buy than there are willing to sell so the price increases until the ones holding are willing to sell. During a bearish trend, the opposite is true; those who want to sell outnumber those who want to buy and, as such, the price falls until people start buying again.
The question is, what sorts of things cause traders to buy/sell currencies en masse and is it possible to predict this by analysing data or reading the signs? Well, unlike in the stock market wherein stock prices are driven by how well a company is doing/how many people want to invest, with forex trading, the value of currencies is mostly related to the interest rates in a currency’s native country or zone. In countries using a centralized banking model (all developed countries plus many less developed countries), interest rates are determined by the central bank.
How do interest rates impact forex currencies?
So, we’ve established that it’s primarily interest rates which affect the value of currencies but, how exactly does it work. Well, if a country’s interest rates are rising, or even if a hike is merely rumoured to be on its way, it is very likely that that country’s native currency will increase in value. Obviously, this depends on the currency pairing.
So, let’s say the US federal reserve has increased interest rates, whereas the UK’s interest rates have remained the same, then the currency pair GBP/USD would be considered a rising market. Conversely, the USD/GBP currency pair would be a falling market. However, bear in mind, savvy traders will often trade based on where they think interest rates will be in the future, not where they are today.
Why do interest rates largely determine the value of forex currencies?
Why do interest rates have such a monumental effect on the forex market? Put simply, it all comes down to bonds – government-issued bonds, to be exact. Think of it this way: just as an individual will take out a loan to buy, say, a house or a car, and then pay interest on said loan until it’s fully paid off, governments also borrow money by issuing what are known as bonds. Bonds, in this sense, are essentially IOUs from governments with an interest coupon rate tagged on.
Say you purchase a $100,000 30-year US Treasury Bond with a 4% coupon, then you’re, in effect, lending the United States Government $100,000 and they are agreeing to pay you $4,000 a year for 30 years, after which, they will refund you the original $100,000. Now, what if you had the option to do the same exact thing in a different country/currency but get 5% interest every year, or 6% or 10%? Obviously, you’d favour the country/currency with the most lucrative interest coupon rate, so long as you had faith that the country/currency in question wouldn’t default on the loan.
As you’ve probably guessed, this is where the forex market begins to come into play. Obviously, if the UK is offering far better interest coupon rates on its bonds than, say, France or Germany, then it is likely that international money (including German and French money, usually via international money managers) will favour the pound over the euro. But, for German or French traders to purchase these attractive British bonds, they must first sell/trade whatever currency it is they are holding (probably euros) and buy GBP.
As such, in this fictional scenario, it is highly probable that the GBP/EUR currency pair will become a rising market, driving the value of the pound up, and the EUR/GBP currency pair will become a falling market, which, conversely, will lower the value of the euro. This is because, due to the favourable interest coupon rates in the UK, the pound is now in higher demand than the euro and, as such, those who are holding euros but want to buy British bonds want to sell their euros and will probably end up doing so at a reduced price. Simple, right?
How do banks determine when to raise interest rates?
If a country’s economy is doing well, interest rates tend to go up, and if a country’s economy is doing poorly, interest rates tend to go down.
So, if there’s news of a couple of hundred thousand new jobs popping up over the course of the next couple of months due to businesses expanding their operations etc., then it is likely the feds (federal reserve, in the case of the US, at least) will seriously consider raising rates.
Obviously, there’s more to it than this but, by keeping a close eye on the news, many traders are able to successfully pre-empt interest rate hikes and get in early or, conversely, sense a lull coming and sell accordingly.
Fundamental analysis & technical analysis
Analysing a market based on the economy, interest rates and corresponding news cycle is referred to as ‘fundamental analysis’. Combining fundamental analysis with technical analysis, i.e., using forex indicators to interpret market trends and data, is what smart traders do. And, of course, the two are intrinsically related.
Moreover, to gain a deeper understanding of forex trading, it is of crucial importance to not only recognise potential trends by analysing data and applying algorithms/formulas, but also to understand why a currency has performed the way it has. Once you’re able to do both simultaneously, then you’ll be able to start taking longer-term positions because you’ll have a much better chance of predicting what will take place weeks, months, even years down the line.
We hope this short guide has provided you with a solid grounding on what sorts of things can make the forex market move and, as always, happy trading!