- Economic factors
Government budget deficits/surpluses: As we know from the macroeconomics, a government’s budget deficits or surplus can be determined with this equation: Y = C + I + G + (X – M), where Y is GDP (income), C is consumption spending, I is private investment spending, G is government spending, X is exports and M is imports (so X – M = net exports). So how we can interpret the government budget deficit or surplus? Actually, this is the difference between what the government takes in, in terms of taxes and duties, and what it pays out in terms of spending in the economy. A budget deficit is seen as being negative for a currency, as the Government would be expected to print money to close this gap and balance the books causing depreciation in the value of the currency.
Economic growth: A currency will do better in most cases when the numbers of the country are better than expected. Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. When an unexpected number is released for growth, you will generally get a ‘knee-jerk ‘reaction and quick move in the currency.
Inflation: Typically, a currency will lose value if there is a high level of inflation or levels are perceived to be rising. This is because inflation erodes the purchasing power, and therefore demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation. When inflation comes in strong, the initial reaction generally is that the currency strengthens
Balance of trade levels: A country will account for the demand for goods and services with other countries through its balance of trade. If a country is a ‘net-importer’ then it will be importing more goods and services from a country then it is exporting. Thus it will then be acquiring more of the target country’s currency to settle trading balances. Therefore, when the numbers for the balance of trade are released, you will see an appreciation in that currency’s price.
- Political conditions
Political upheaval in the economy is a reason for the currency to be sold off. In G7 currencies, this does not happen much as the governments are viewed as stable, but this is more so for the emerging market currencies
- Market psychology
Psychology always changes in the markets and there are always new reasons to buy or sell a currency, so it is worth noting that trading styles should be flexible and readily changeable. Market psychology responds to the trend of the currency pair, but other reasons are affecting it as well.
Economic figures: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number it self becomes important to market psychology and may have an immediate impact on short-term market moves. “What to watch” can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.
Long-term trends: Currency markets often 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 analysts will look at longer-term price trends that may rise from economic or political trends.
Technical trading setups: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.
Flight to Quality: When there are unsettling international events, there is usually a ‘flight’ with investors finding a safe haven. Of all the currencies, the Swiss franc (CHF) is seen as a safe haven so it will usually appreciate during a period of uncertainty.
"Buy the rumour, sell the fact": This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being ‘oversold ‘or ‘overbought’. To buy the rumour or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices. For example, if there is a rumour that the Bank of England is going to cut rates, GBP/USD may get sold initially, but once the rate cut is officially announced the market will have expected it so the traders who were short GBP/USD, may buy back their positions; hence the market may get bought.
Nicknames: The well known story of the cable has its origins from the communication cable running under the Atlantic Ocean and connecting New York and London markets. Other common nicknames are Greenback for USD, Aussie for AUD/USD, Loonie for USD/CAD, "Swissy" or "Euro-Swissy" for EUR/CHF, Yuppy for EUR/JPY & Guppy for GBP/JPY, Chunnel for EUR/GBP, Kiwi for the New Zealand Dollar NZD/USD. The term ‘fibber’ for EUR/USD was never really adopted by European traders as they expected euro to be a stronger currency against the USD.
The euro-dollar exchange rate is the price at which the world demand for US dollars equals the world supply of euros. Regardless of geographical origin, a rise in the world demand for euros leads to an appreciation of the euro.
Four factors are identified as fundamental determinants of the real euro to dollar exchange rate:
- The different fiscal policy between Federal Reserve and the ECB
- Different inflation prices
- The international real interest rate differential
- Relative prices in the traded and non-traded goods sectors
In the current period of the economic cycle we can find significant discrepancies between euro and the dollar, mainly because of the big shifts from the two largest central banks in the world. While Fed is tightening (waiting to raise rates within 2015) after a long period of low interest rates and an enormous QE which boosted the balance sheet to over $4 trillion USD, the ECB has just decided to implement a €1.2 trillion QE until September 2016 to help the economic growth and falling inflation prices in Eurozone.
The big shift was from ECB’s side: When Mario Draghi introduced easing in 2014 with a an extended TLTRO program and increased ABS purchases to broaden the balance sheet, traders started selling EUR/USD heavily. As inflation prices were down to 0.3% at the beginning of 2015 from 0.8% a year ago due to low demand and falling oil prices, the ECB introduced a €1.2 bond buying program to help Eurozone recover. The tremendous difference between the policies of ECB and Fed turned investors to the ‘safety’ of greenback. EUR/USD lies in a big downtrend which could only change if the Fed changed the plans about the rate hikes or Euro zone economy posted much better than expected numbers. Let’s see the basic theories underlying the EUR/USD exchange rate:
Law of One Price: In competitive markets free of transportation cost barriers to trade, identical products sold in different countries must sell at the same price when the prices are stated in terms of the same currency.
Interest rate effects: If capital is allowed to flow freely, exchange rates become stable at a point where equality of interest is established.
The dual forces of supply and demand determine euro vs. dollar exchange rates. Various factors affect these two forces, which in turn affect the exchange rates:
The business environment: Positive indications (in terms of government policy, competitive advantages, market size, etc.) increase the demand for the currency, as more and more enterprises want to invest there.
Stock market: The major stock indices also have a correlation with the currency rates.
Political factors: All exchange rates are susceptible to political instability and anticipations about the new government. For example, political or financial instability in Russia is also a flag for the euro to US dollar exchange because of the substantial amount of German investments directed to Russia.
Economic data: Economic data or indices such as labor reports (payrolls, unemployment rate and average hourly earnings), consumer price indices (CPI), producer price indices (PPI), gross domestic product (GDP), international trade, productivity, industrial production, consumer confidence etc, also affect fluctuations in currency exchange rates.