There are various basic variables that influence the long-term strength or weakness of the major currencies and, as a result, how you trade forex.
We’ve included the ones we believe are most important for your reading pleasure:
Economic Growth and Outlook
We begin with the economy and the expectations of consumers, corporations, and governments.
When consumers see a robust economy, it’s easy to see why.
Consumers are content and secure, so they spend money. Companies gladly accept this money and proclaim, “Hey, we’re making money!” Wonderful! Now… what are we going to do with all this money?”
Companies that have money spend it. All of this generates significant tax money for the government.
They hop on board and begin spending money. Everyone is now spending, which has a beneficial influence on the economy.
Weak economies, on the other hand, are frequently followed by consumers who aren’t spending and firms that aren’t making any money and aren’t spending, leaving the government as the only one who is still spending. But you get the point.
Positive and negative economic forecasts can both have a direct impact on currency markets.
GDP is the most often used measure of economic growth.
GDP is an abbreviation for “Gross Domestic Product,” and it indicates the total monetary worth of all final goods and services produced (and sold) within a country over a given time period (typically one year).
GDP gives an economic snapshot of a country and is used to determine the size and growth rate of an economy.
Here’s a HowMuch.net visualization that illustrates the $86 TRILLION global economy in a single chart:
As can be seen:
- The United States continues to have the world’s largest economy.
- China’s economy is the world’s second largest.
- The United States and China account for almost 40% of global economic GDP.
- The top 15 economies account for 75% of total global GDP.
Globalization, technical advancements, and the internet have all contributed to the simplicity with which you can invest your money almost anywhere in the globe, regardless of where you live.
You’re only a few mouse clicks (or phone calls for those of you living in the Jurassic period of the 2000s) away from investing in the New York or London stock exchanges, trading the Nikkei or Hang Seng indexes, or opening an FX account to trade US dollars, euros, yen, and even exotic currencies.
Capital flows are the amounts of money that flow into and out of a country or economy as a result of capital investment purchases and sales.
The most crucial factor to monitor is capital flow balance, which might be positive or negative.
When a country has a positive capital flow balance, foreign investments into the country outnumber those leaving the country.
A negative capital flow balance is the inverse. Investments leaving the country for some international locations outnumber those coming in. As more investment flows into a country, demand for that country’s currency rises because foreign investors must sell their currency in order to purchase the local currency.
The currency’s value rises as a result of the increased demand.
It’s as simple as supply and demand.
And, you got it, when a currency’s supply is high (or demand is low), the currency tends to lose value.
When foreign investments reverse course and domestic investors want to switch teams and leave, there is an abundance of local currency because everyone is selling and buying the currency of the foreign country or economy in which they are investing.
Nothing attracts foreign capital more than a country with high interest rates and good economic growth. Even better if a country has a growing domestic financial market!
A thriving stock market and high interest rates… What’s not to love about this? Foreign investment is pouring in.
Again, as the demand for the local money grows, so does its value.
Trade Flows and Trade Balance
International trade can be divided into two categories: trading in goods (merchandise) and trade in services. The majority of international trade is for physical items, with services accounting for a significantly smaller portion.
Over the last decade, global trade in products has expanded considerably, growing from almost $10 trillion in 2005 to more than $18.89 trillion in 2019.
We live in a globalized world. Countries sell their own goods to ones who want them (export), while simultaneously purchasing goods from other countries (importing).
Examine your surroundings. The majority of the items laying around (electronics, apparel, puppy toys) were most likely manufactured outside of the country you live in.
Look at all of the countries with which the United States trades if you live in the United States.
You have to give up some of your hard-earned money every time you buy something.
Whoever you purchase your widget from must do the same.
When purchasing goods, US importers exchange money with Chinese exporters. When Chinese importers buy goods, they swap money with European exporters.
All of this buying and selling is accompanied by money exchange, which alters the flow of currency into and out of a country.
The trade balance (also known as the balance of trade or net exports) of a given economy is the ratio of exports to imports.
It reflects demand for that country’s goods and services, as well as its currency.
If exports exceed imports, there is a trade surplus and the trade balance is positive.
A trade deficit exists when imports exceed exports, and the trade balance is negative.
Exports > Imports = Trade Surplus = Positive (+) Trade Balance
Imports > Exports = Trade Deficit = Negative (-) Trade Balance
Trade deficits have the potential to lower the value of a currency in comparison to other currencies.
Net importers must first sell their currency in order to purchase the currency of the overseas merchant offering the items they desire.
When there is a trade deficit, the local currency is sold in order to purchase foreign goods.
As a result, the currency of a country with a trade deficit is in lower demand than the currency of a country with a trade surplus.
Net exporters, or countries that export more than they import, have their currency purchased more frequently by countries interested in purchasing the exported commodities.
Currency appreciation is common when there is a trade surplus.
It is in higher demand, which is helping their currency gain value.
It’s all because of the currency’s DEMAND.
This is because when exporters convert the foreign currencies they earn overseas into their local currency, the domestic currency tends to rise in value.
Currencies in higher demand tend to be more valuable than those in lower demand.
The Government: Present and Future
After the Great Financial Crisis (GFC) produced the Great Recession in the late 2000s, all eyes were on their individual governments, wondering about the financial troubles being faced and hoping for some fiscal prudence to stop the woes felt in our wallets.
We are now in a similar predicament a decade later, as the globe attempts to negotiate a worldwide health crisis and economic collapse triggered by the coronavirus (COVID-19) pandemic.
Instability in the existing government or changes in the current administration can have a direct impact on the economy of that country as well as adjacent countries. And any impact on an economy will almost certainly have an impact on exchange rates.
Next Lesson: Where to Find Forex News and Market Data