What influences exchange rates
Before we look at the factors and players that influence the exchange rates, we must understand how these rates affect economies. First of all, exchange rates influence the trading relationship between countries, which is a major concern for the central banks.
Let’s look at EUR/GBP currency pair. If the British pound increase in value against the euro, it makes the British exports more expensive for European buyers. For example, it will become more expensive for a car dealer from France to buy Mini Cooper cars from the UK as it will require more euros to buy the same amount of pounds. So UK exports would decrease.
A higher pound would also negatively affect British tourism, as almost everything would become relatively more expensive in Britain. The overall balance of trade will decrease if the currency value is higher.
On the other hand, if the value of British pound would decrease, it would make the British exporters more competitive and the overall exports would increase.
Therefore, countries are constantly trying to sustain a healthy exchange rate in order to help their exporters. It is a very challenging task because a low currency rate can be good for exporters, but it is usually not so good for businesses that import goods because those goods will become more expensive for them.
Central banks are in a constant struggle to achieve and maintain an exchange rate that would be good for all sides of their economy.
The golden rule of economic indicators
You must understand where the indicators are found and how to read them. All of the previous and upcoming reports about the economic indicators are available in economic calendars.
And here is the fun part – The currency rates often start moving even before the actual data comes out!
Markets start moving from expectations and forecasts that are also available in the calendars. If the forecast promised a positive growth and the actual data comes out even better than forecasted, it amplifies the rise of the currency even more.
If the actual data comes out worse than expected, it creates a strong downward pressure on the currency.
Here is the rule to remember with financial reports: Actual > Forecast = Good for currency
To illustrate this rule, let’s look at an economic calendar and compare the GDP growth indicators (month-to-month) of the US and Canada and see how these indicators would influence the USD/CAD exchange rate.
For example, US’s GDP growth, is +0.4% and what forecasts predicted was +0.1% and Canada have the same GDP growth rate of +0.4%, but what forecasts predicted was +0.6%. So the winner here is the country that surpasses the forecasts – which is the US. Canada’s actual numbers were worse than expected so forex traders will take this as a bad sign for the Canadian economy and the CAD will decrease against the USD.
1-Raising interest rates
Raising interest rates, obviously has the opposite effects to cutting them, so we will not go through all the same points.
Interest rates are one of the most important indicators for forex traders who use fundamental analysis. If money makes the world go round, interest rates make the money go round. For example, the higher interest rates are in the US relative to other countries, the more attractive it is to deposit money in the US. The return from savings is better and so the demand for USD increases.
Therefore, a country with the highest interest rates attracts more foreign investments, and their currency rate drives up in the long term.
How do interest rates work? If the economy is in a downturn and companies are nervous about the future and are reducing investments, a central bank can lower the overnight rate that it charges smaller banks for borrowing money. This charge is called “interest rate”. If the central bank reduces the base interest rate, this will usually cause commercial banks to reduce their own interest rates as well. Lower interest rates make it cheaper to borrow. This tends to stimulate investment and spending, which then leads to economic growth.
When the markets are expecting an interest rate increase, the currency tends to appreciate. That’s one of the reasons why the USD was appreciating against other currencies at the beginning of 2015 when the Fed was considering raising interest rates.
The exception to this rule is when a country increases the interest rate to save a falling currency. For example, during the crisis between Russia and Ukraine, the Russian Central Bank raised its interest rate from an already high 10.5% to a staggering 17% in a desperate attempt to rescue the falling rubble. All of the money was being withdrawn from Russian banks and the government had to do something to stop it.
Who controls interest rates
The interest rates are controlled by the central banks. Here are 8 most influential Central Banks:
● US Federal Reserve Bank (USD)
● European Central Bank (EUR)
● Bank of England (GBP)
● Bank of Japan (JPY)
● Swiss National Bank (CHF)
● Bank of Canada (CAD)
● Reserve Bank of Australia
● Bank of New Zealand (NZD)
Interest rate timing
To maximize the profits, experienced traders do not wait for the announcement of an interest rate hike or cut. You need to be ahead of the curve and read the subtle signs that precede a change in short-term interest rates.
Keep in mind that when a country with a lower interest rate starts to increase rates, it may attract investors even though that country’s rate is still nominally lower than where the big investor’s money currently is.
Smart investors will try to get in early on the side of the currency, which may have increasing rates in the future.