Let's explore the key factors that drive FX spot rates focusing on some of the most common economic and market variables. Currencies are influenced by a variety of factors, but they generally fall into a few major categories.
One of the most direct drivers of currency value is the difference in interest rates between two currencies. Higher interest rates in one currency tend to attract capital inflows, strengthening that currency relative to others. Over the longer term differences in inflation rates also drive currency movements.
Currencies from countries with lower inflation tend to appreciate against those with higher inflation as they maintain purchasing power over time. Higher inflation means you need to pay more units of your currency to buy goods and services domestically, but that can also apply to buying foreign currency as well.
Indicators like GDP growth, employment data, or trade balances provide insights into an economy's health.
Positive economic news can strengthen a currency by attracting investment.
Central bank actions and guidance significantly impact FX markets. Rate hikes, cuts or quantitative easing can shift expectations and influence currency values.
Political uncertainty can deter investment and weaken a currency while politically stable. Countries often see their currencies act as safe havens.
For instance, the US Dollar, Swiss Franc and Japanese Yen tend to strengthen during periods of global uncertainty.
Purchasing power parity is a long-term concept suggesting that currency values should adjust to equalize the cost of goods between countries. While not a short-term trading tool, purchasing power parity provides a useful benchmark for evaluating whether a currency is overvalued or undervalued. To see these concepts in action, let's examine this chart, which highlights the impact of interest rate differentials. It plots the Euro US Dollar spot rate against the interest rate differential on two year government bonds in the Eurozone and the US.
When US rates are increasing relative to Euro interest rates, Euro US Dollar often weakens reflecting US Dollar strength. Conversely, when Eurozone interest rates rise relative to US rates, Euro, US Dollar tends to strengthen.
What's important to remember though is that while interest rate differentials are critical, they don't act in isolation. For instance, a central bank raising rates to combat inflation could influence both the interest rate differential and inflation expectations, amplifying the impact on FX spot rates. Additionally, short-term divergences can occur, for example, geopolitical events or sudden changes in monetary policy might drive FX moves that don't immediately align with interest rate differentials or inflation expectations.
