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10 Key Factors that Affect the Foreign Exchange Rates

One of the most important considerations in gauging a country’s economic health is the foreign exchange rates.  The country’s foreign exchange rate gives us a window to its economic stability. If you are planning to send or receive money overseas, you must check these rates.

foreign exchange rates shown on a bulletin

What are foreign exchange rates?

Its book definition runs: “the rates at which one country’s currency may be converted into another. This rate may fluctuate on a daily basis as market forces change along with supply and demand.

There are several factors that affect foreign exchange rates. Changes in a country’s economic data are much more immediate. Most of the time, the biggest companies are various countries that participate in market activities.

In this article, we will discuss the various factors that affect foreign exchange rates. If you are an aspiring trader or investor of currencies, you should read this article!

Factor 1: Non-farm Payrolls

Non-farm payrolls refer to the data of the number of people with jobs within the US economy. The Bureau of Labor Statistics releases this data every first Friday of every month.

Huge slumps in employment signals a contracting economy. Meanwhile, strong increases usually mean a robust economy.

Factor 2: Interest Rates

Changes in interest rates also affect currency value and dollar exchange rates. Foreign exchange rates, interest rates, and inflation rates are all connected.

When the central bank decides to raise interest rates, the country’s currency tends to appreciate in value. This is because higher interest rates offer higher rates to lenders. And that attracts more foreign capital, which bolsters exchange rates.

Factor 3: Inflation Differential

Normally, a country with consistently low inflation rate has a rising currency value. That’s because it purchasing power increases relative to other currencies.

In the latter half of the 20th century, countries with low inflation were Japan, Switzerland, and Germany. US and Canada managed to get lower inflation only later.

Countries with higher inflation usually see their currencies depreciate against other currencies. Afterwards, higher interest rates follow.

Factor 4: Current Account Deficit

The current account refers to the balance of trade between a country and its trading partners.  This reflects all payments between countries for services, products, and dividends.

A deficit in the current account indicates the country spends more on foreign trade than it is earning. It also means that the nation is borrowing capital from foreign sources to make up the deficit.

Put another way, the country needs more foreign currency than it receives through export sales. It supplies more of its own currency than foreign demands for its goods. The excess demand for foreign currency stunts the country’s exchange rate. This will continue until goods and services are inexpensive enough for foreigners and foreign assets are too expensive to generate sales for domestic products.

[See also: Fundamental Analysis: Qualitative Factors of the Company]

Factor 5: Public Debt

Countries engage in large-scale deficit financing to pay for governmental funding and public projects. Even though the activity stimulates the domestic economy, foreign investor find countries with large public deficits and debts less attractive.

The reason behind this is that large debt encourages inflation. And when inflation is high, one will have to pay the debts with cheaper real dollar.

If worse comes to worst, a government may print money to pay part of a huge debt. However, increasing the money supply causes inflation. Further, if a government fails to service deficits via domestic methods, it has to increase the supply of securities for sale to foreigners.  That means lowering their prices.

Eventually, a huge debt may prove a concern to foreigners. They may worry that the country risks defaulting on its obligations. Foreigners will not be very willing to own securities in that currency if the risk of default is quite large.

Factor 6: Gross Domestic Product

This measures the amount of goods and services the country finishes over a period of time. The GDP comprises four categories, which are:

  • Business spending
  • Governmental spending
  • Private consumption
  • Total net exports

Factors 7: Retail Sales

This is another important factor to consider. Retail sales report from retailers over a period of time reflects either increased or decreased consumer spending.  This depends whether  sales are higher or lower when you compare them with a year ago.

This indicator provides the market participants some clues about how strong or weak the current economy is.

Factor 8: Terms of Trade

The terms of trade is one kind of ratio comparing export prices to import prices. The terms of trade relates to current accounts and the balance of payments.

If the price export increase is higher than that of its imports, the terms of trade have favorably improved. Higher terms of trade signify higher demand for the country’s exports. In turn, this leads to rising revenues from exports.

Rising revenues from exports gives higher demand for the country’s currency and an increase in the currency’s value.  If the price of exports rises by a smaller percentage than that of imports, the currency’s value will depreciate.

Factor 9: Political Stability and Macroeconomic Events

Foreign investors search for stable countries with strong economic performance where they can invest their capital. A country with such quality will attract investment funds away from other countries that are more politically and economically unstable.

Political turmoil, for instance, can lead to a loss of confidence in a currency. It can also result to a movement of capital to the currencies of more stable countries.

Elections, financial crises, monetary policy changes, and wars can affect foreign exchange rates. They can be the biggest changes in the forex market. Such events can either make or break or reshape a country’s economic growth.

Factor 10: Speculation

If a country’s currency value gravitates toward rising, investors will demand more of that currency. That’s because they want to gain more profits in the near future. This results to an increase in the currency’s value thanks to higher demand.

With the increase in currency value comes an increase in the foreign exchange rates.

Conclusion

The exchange rate of the currency where a portfolio’s huge slice is allocated can determine a portfolio’s real return.  A falling exchange rate obviously diminishes the purchasing power of the income and capital gains from any returns.

Further, the foreign exchange rates affect other income factors like interest rates, inflation, and even capital gains from domestic assets.

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