Whilst there might be many factors influencing exchange rates, ultimately, currency prices are a result of supply and demand forces. Affected by a large and ever-changing mix of current events, supply and demand factors constantly change, and simultaneously influence the price of one currency in relation to another. No other market encompasses as much of what is going on in the world at any given time as foreign exchange.
Supply and demand for any given currency, and thus its value, are not influenced by any single factor, but rather by several. These factors generally fall into three categories: economic factors, political conditions and market psychology.
i. Economic factors
These include economic policies initiated by government agencies and central banks, economic conditions, which are generally revealed through economic reports, and other economic indicators.
Economic policy comprises of fiscal and monetary policies. Whilst the former encompasses a government’s budget or spending practices; the latter invlovles central banks trying to influence the supply and “cost” of money by configuring a suitable level of interest rates.
Economic conditions include:
a. Government budget deficits or surpluses
The market usually reacts positively to narrowing government budget deficits, and negatively to widening budget deficits. The impact is reflected in the value of a country's currency.
b. Balance of trade levels and trends
Trade flows between countries illustrates the demand for goods and services, which in turn depicts the demand for a country's currency to carry out a trade. Surpluses and deficits in trade of goods and services reflect the country’s economic competitiveness. For example, trade surpluses may have a positive impact on a nation's currency.
c. Inflation levels and trends
Inflation erodes purchasing power. This can in turn affect demand for that particular currency. Generally, a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising.
d. Economic growth and health
Reports such as employment rates, gross domestic product (GDP), , retail sales, capacity utilization and others, illustrate the levels of a country's economic growth and condition. Typically, the healthier and more robust a country's economy, the better its currency will perform, and the more demand for that currency.
e. Political conditions
Internal, regional events, and international political conditions and events can have a significant impact on currency markets.
Political instability can have a negative impact on a nation's economy. On the other hand, the emergence of a political faction that is perceived to be fiscally responsible can have a positive effect. Regional may also induce positive or negative interest in a neighboring country and, in the process, affect its currency.
ii. Market psychology
Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:
a. Flights to quality
Destabilising international events can lead to a "flight to quality," with investors seeking a safe option. There will be a greater demand, for currencies perceived as stronger over their relatively weaker counterparts. This translates to a higher price for the stronger currencies.
b. Long-term trends
Similar to other instruments, currency markets usually move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends.
c. "Buy the rumor, sell the fact"
This market axiom can be applied to many currency situations. It is the tendency for the price of a currency to factor in the impact of an expected action before it occurs and, when the anticipated event happens, react in exactly the opposite direction. This can be viewed as a market being "oversold" or "overbought". To buy the rumor or sell the fact can also be an example of the subconscious inclination known as anchoring, when investors focus too much on the relevance of “noise” of external events instead of actual currency prices.
d. Economic numbers
While economic numbers can certainly reflect economic policy, some reports and numbers do not take the actual effect as perceived, the market becomes fixated on the language or number itself and this may have an immediate impact on short-term market fluctuations. What is perceived as important reports or numbers can change over time. In recent years, employment, money supply, trade balance figures and inflation numbers have taken turns in the spotlight.
iii. Technical trading considerations
The cumulative price movements in a currency pair may form patterns that can be recognized and utilized by traders for the purpose of entering and exiting the market, leading to short-term fluctuations in price. Many traders study price charts in order to identify such patterns.