Forex traders in the UK and beyond are staying alert this week, as the value of the British pound continues to decline against the Euro, US dollar and other major currencies. As Brexit negotiations continue and a “no-deal” Brexit remains a real risk, the value of the pound is serving as a sign of market confidence in Britain’s ability to reach a workable and timely deal with the EU to secure a smooth exit by the March deadline.
The pound is not in crisis, but it is certainly in an unstable position due to uncertainty over Brexit negotiations. This is not a surprise to experienced forex traders. There are many factors that affect the forex market, and political uncertainty and instability is just one of them. Here are a few others that successful traders keep an eye on:
Fluctuations in a country’s inflation rate have a direct impact on currency exchange rates. A low rate of inflation in any country will see that country’s currency appreciate in value against the currencies of other countries with higher inflation. High inflation means that currency will see some depreciation against other currencies. This is partly due to the fact that inflation is, of course, tied tightly to other important factors within a national economy, including the price of goods and services and national interest rates.
If you are actively forex trading, then you will want to keep a close watch on the interest rates of all the countries whose currencies that you are trading. Interest rates, inflation and forex rates are all intertwined, and a sudden decline in interest rates in a particular country will cause a drop in the value of its currency. Conversely, even the possibility of an imminent rise in interest rates can cause a currency to appreciate if investors trust that the country can increase interest rates without triggering an accompanying increase in inflation.
This is because higher interest rates will attract foreign investment, which will increase the demand for the base currency of the country. To the citizens of a country, many of whom are in debt, high-interest rates are rarely welcome, but for investors, high-interest rates are a very good thing.
National debt also affects currency. Generally speaking, a low national debt indicates economic strength, and a country is less likely to attract foreign investment and the accompanying increase in demand for its base currency if its national debt is high. In practice, however, the national debt is complicated, and investors measure economic strength not in terms of absolute national debt but in the country’s assets, income and ability to continue to manage that debt effectively.
When a country looks like it can no longer manage its national debt and is likely to default on it, this is when forex traders will see a big impact on that country’s currency. Countries that face a national debt crisis, as Argentina did in 2001, will often opt to devalue their currency as part of their plan to repay debt and regain economic stability.
As the two points above have touched on, foreign investment rates have a big influence on the value of a country’s currency. A country’s economy reflects the balance of trade and its earnings on foreign investments. This closely ties to imports and exports and is one of the reasons that the uncertainty over a Brexit deal and the impossibility of accurately predicting what that deal will mean for the UK’s balance of trade is so disconcerting.
A decrease in foreign investment will decrease the value of a country’s currency. Alongside this, a deficit in a country’s balance of payments due to spending more of its currency on imports than it is earning through exports will also cause currency depreciation, so the balance of payments is invariably correlated with currency fluctuations.
Closely related to imports, exports and the balance of payments is a country’s terms of trade. This basically represents the ratio between a country’s export prices and import prices. Terms of trade is a percentage reached by dividing the price of exports by the price of imports and then multiplying that figure by 100. When that figure is less than 100%, the country is spending more on imports than it is generating through exports. When it is higher than 100%, the country is receiving more revenue from exports than it is spending on imports. Higher revenue leads to a higher demand for that country’s currency, which will lead to an appreciation in value of that currency.
A major economic recession can have a global impact, as we are all aware, but it is not unusual for an individual country to experience a recession due to local events and issues that impact the national economy or major employment sectors within that economy. During a recession, national interest rates tend to fall, which, as already discussed, leads to a decrease in that all-important foreign investment. As a result, the currency of that country will depreciate.
Another less tangible factor that will affect currency rates is speculation. If a country’s currency should rise in value in the near future, then investors will buy more of that currency, pushing the value of the currency up purely due to the increase in demand. Many factors influence investor speculation, and it is common in times of uncertainty, particularly as solutions to political and economic issues develop. If, for example, Brexit negotiations start to look more positive or workable solutions for the specific problems facing the negotiators start to emerge, then expect the pound to increase in value again as speculators predict a more stable future or at least a smoother transition out of the EU for the UK.
Forex trading is about keeping a cool head and a sharp eye on the global economic news. Smart forex traders learn to incorporate everything that affects global currency markets into their overall forex trading strategies.