C. What Affects FX Rates?
Investors who make currency pairs move as they buy and sell different currencies, but these investors buy and sell for a reason. In other words, they watch the fundamentals and make their decisions according to what they see. The transaction demand for money is highly correlated to the country's level of business activity, gross domestic product (GDP), and employment levels.
The more people there are unemployed, the less the public as a whole will spend on goods and services. The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.
The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. Trade deficits may have a negative impact on a nation's currency.
Central banks are always on the lookout for rising inflation. When they see inflation rising to uncomfortable levels, they do whatever they can to curb that growth. One tool central banks use to curb inflation is interest rates - central banks can combat rising inflation by raising interest rates. Higher interest rates make it more difficult for businesses and individuals to borrow money to buy and build new items, which slows economic growth and, as a result, inflation. Typically 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. This is because inflation erodes purchasing power, thus 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.
Reports such as GDP (GDP represents the total value of a country's production during the period and consists of the purchases of domestically produced goods and services by individuals, businesses, foreigners and the government), employment levels (Payroll employment is a measure of the number of people being paid as employees by non-farm business establishments and units of government.), retail sales (Retail Sales are a measure of the total receipts of retail stores), durable goods orders (are a measure of the new orders placed with domestic manufacturers for immediate and future delivery of factory hard goods) and others, detail the levels of a country's economic growth and health. The stronger the economy is, the higher the demand for workers becomes. As demand for workers goes up, wages for those workers also goes up. The more money workers take home in their pay checks, the more money they have to spend at retail stores, on cars and on houses. As demand for goods and services increases, the price for those goods and services also increases in other words, inflation. Naturally, if central banks watch inflation indicators (like the CPI and PPI) in their decision-making process, you would assume they would also be interested in watching economic strength indicators to see how strong an economy is and they most certainly are.
Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be. Increasing productivity in an economy should positively influence the value of its currency. If the economic fundamental in a country is improving, this countries currency will most likely be getting stronger. Conversely, if the economic fundamental in the country is declining, the country will most likely be getting weaker.
Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions. The speculative demand for money is much harder for a central bank to accommodate but they try to do this by adjusting interest rates. An investor may choose to buy a currency if the return (that is the interest rate) is high enough. The higher a countries interest rates, the greater the demand for that currency.
Market psychology and trader perceptions influence the foreign exchange market in a variety of ways. Unsettling international events can lead to a "flight to quality," with investors seeking a "safe haven." There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The Swiss franc and gold have been traditional safe havens during times of political or economic uncertainty. 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 rumor 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. "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. 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.