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3 KEY DRIVERS OF THE FOREX MARKET EVERY TRADER SHOULD KNOW

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3 KEY DRIVERS OF THE FOREX MARKET EVERY TRADER SHOULD KNOW

Trading the forex markets is a dynamic and exciting process, and also a steep learning curve. The internet has opened up a truly global forex marketplace where billions of dollars are traded each day. It is no longer an exclusive club open only to a handful of elite bankers, but can be accessed by anyone with a computer and an internet connection.

 

However, the wider playing field is highly liquid and competitive, and it’s essential to have a sound trading strategy if you want to give yourself a good chance of making steady profits.

 

One of the best ways to prepare yourself for a trading career is to gain a good understanding of the factors that influence forex market movement. Here are three key drivers to look out for. 

 

Monetary policy

Monetary policy refers to the actions deployed by a central bank to control interest rates and money supply. Every country has a central bank, such as the Federal Reserve Bank of America, the Bank of England, the European Central Bank, the Bank of Japan, and the Swiss National Bank. 

 

They have a mandate to safeguard the economy by nurturing steady growth, keeping inflation in check and maintaining high employment rates. The main way they are able to do this is through monetary policy. They are able to set the base rate of interest, which means the amount of interest that is added to loans and is accumulated through savings. 

 

Central banks can also control the amount of money that is in circulation at any given time to regulate the economy and help prevent it from overheating or becoming too sluggish. These factors have a huge influence on the forex markets. 

 

There are two main types of monetary policy that forex traders should be aware of: expansionary monetary policy and contractionary monetary policy. 

 

Expansionary monetary policy

Expansionary monetary policy is deployed when the central banks want to grow the economy. They can do this by increasing the money supply through methods such as quantitative easing (QE), buying or selling government bonds, and lowering interest rates in order to encourage borrowing, which in turn boosts spending and investment. 

 

This drives up productivity and brings extra jobs so that employment rates are high. During the Covid crisis, central banks dropped interest rates to historically low levels of below 1% in an attempt to shore up the global economy against the effects of the lockdowns. 

 

One example of the effect this had in the UK was to stimulate the housing market, as borrowers took advantage of low interest mortgage deals. Coupled with a complementary government measure of suspending stamp duty, this led to a boom in demand and house prices rose at historic levels. 

 

Contractionary monetary policy

The opposite of this approach is known as restrictive or contractionary monetary policy. They usually take this tactic when prices are rising too fast, as measured by the inflation rate, and the central banks attempt to restrict economic activity. 

 

The main way they do this is by raising interest rates so that borrowing money is less attractive to businesses and private consumers. This discourages spending and investment, so that prices are eventually driven back down. 

 

We are currently experiencing a period of high inflation driven by the aftermath of the pandemic and the war in Ukraine, which has driven up energy and food prices. In response, the interest rate in the UK is currently at 5%, the highest level since the financial crisis of 2008/9. 

 

On the occasions when the economy is ticking over nicely, neither overheating or stagnating, central banks follow a neutral monetary policy to maintain the stability. Monetary policy affects everybody, from the cost of our monthly mortgage payments to the amount we pay for our weekly shopping basket.

 

Monetary policy is a key driver of the forex markets. When a contractionary policy is implemented and interest rates are increased, this drives up the value of a currency, because foreign investors are able to get a better return on their capital, which will involve exchanging their currency for the one relevant to their chosen destination. 

 

Conversely, when interest rates are lowered, a currency depreciates in value because foreign traders will take their capital elsewhere. Therefore, forex traders need to keep a close watch on both the inflation rate and the interest rate of the countries relevant to their currency pairs as this will be a strong indicator of when to buy and when to sell. 

 

Geopolitical events

Politics and economics are closely related, and so geopolitical events can have a knock-on effect on the financial markets. Here are some major geopolitical events to monitor carefully for the impact on the value of your currency pairs.

 

Elections

When a country holds a general election, this is regarded as a time of uncertainty and this creates more volatile trading conditions. This is because a different government may make changes to monetary policy.

 

As we have seen, a country’s monetary policy is the key driver of the forex markets. Some political leaders are concerned with boosting economic growth above all else, while others are more concerned with redistribution of wealth and investment in public services. 

 

Therefore it is crucial to take note of which countries are facing major political elections and to keep an eye on the polls to see if a change of government is predicted. Stay well informed about the ideologies of the major political parties and what their economic policies are. 

 

If there is a strong opposition and their policies are radically different to the current government’s, then this may lead to some turbulence in the forex markets and the devaluing of the currency. 

 

Any political change at all is likely to have an impact, but if the election has been called unexpectedly due to scandal, civil unrest, or political party infighting, then the currency price is likely to be severely impacted. Once the period of uncertainty is over, most of the major currencies will tend to settle again. 

 

Natural disasters

Natural disasters such as hurricanes, floods, and earthquakes are not only devastating for the country’s people, but also for the national economy and therefore the value of the currency price. Infrastructure and factories may be damaged, affecting supply chains and production. 

 

The workforce may also be affected through death, disease and injury that are sadly the result of such events. Large scale disasters can also create mass homelessness and migration. The clean up and rebuilding operation diverts government resources from other forms of investment that would boost the economy and encourage overseas investment. 

 

Wars

Civil wars or international conflicts have a severe and immediate impact on the currency value of the countries involved. Much like natural disasters, wars damage and destroy infrastructure and power supplies, disrupting industry and agriculture. Furthermore, economic and trade sanctions may be imposed on the country for political reasons.

 

The longer a conflict continues, the more the economy is drained and therefore the currency price will be highly volatile. There may be some bounceback once a resolution has been reached and the government invests in rebuilding programmes and seeks to stimulate the manufacturing sector.

 

Trade deficits

The balance of trade between countries is an important indicator of how in demand its goods are. A country with a high demand for its goods will tend to have a strong currency value because it will usually export more than it imports. On the other hand, a country that tends to import more than it exports will usually have a weaker currency value.

 

However, the balance of trade is not fixed but fluctuates over time. This could be in response to seasonal demand, political events, or the supply of raw materials. When a country is buying more goods and services than it is selling to foreign markets, it is described as having a ‘trade deficit.’

 

Some countries are rich in natural resources that will always be in high demand, such as oil, gas, and timber. However, the prices of these commodities fluctuate depending on economic conditions that affect demand, so this will impact the currency value.

 

While a country with a persistent and deep trade deficit may have a weaker currency value, it can be a complicated situation and some countries with strong economies have long standing trade deficits, such as the USA.

 

Conclusion

As well as all of these major factors, it’s also important to keep your eye on the economic calendar to stay well informed about the smaller day to day events that can help to shape your trading strategy. There are plenty of online tools available to help you do this, and many of them also carry a prediction of how volatile the market reaction will be.

 

Utilising this type of data and news to inform your trading strategy is known as fundamental analysis, and you should build it into your daily trading routine so that it becomes second nature. When combined with some technical analysis tools, it will give you the best insight and understanding of the forex markets, improving your confidence and trade outcomes.


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