If you are trading Forex, then knowing the factors that affect the exchange rate is crucial, but before we start, we need to begin by stating the obvious. First, the exchange rate is determined by pairing between the value of two currencies. Second, exchange rates are quoted in terms of how much of a currency you can buy with another currency so, the exchange rate for the pound sterling of 1.40 means that each pound will cost you 1.4 dollars to buy it.
The exchange rate invariably fluctuates unless a currency is fixed against another. For example some Caribbean and Arab countries fix their currency with the US dollar.
Factors that affect the exchange rate might be too many to sum, but the value of a country’s currency is determined by a few important ones; the most important is the interest rate in that country. the interest rate can be tempered by inflation in the country or its political stability. High interest rates attract foreign currencies to that country, improving the demand for the country’s currency, therefore, its exchange rate will increase in value as investors buy more of that currency with their country’s currency.
Forex traders always try to anticipate interest rate changes as they can significantly affect exchange rates. There are conditions where traders need to be cautious and realistic as market participants anticipate the change and incorporate it in the price before the announcement of the interest rate.
Traders shouldn’t just be attracted to high interest rates, because the benefit of high interest rates can be negated by high inflation which reduces the purchasing power of the currency and so, reduce real return that could be gained with the increase of the interest rate. Some of the highest interest rates can be found in very volatile countries. Investors also need to be sure that their funds remain relatively liquid as many of these countries restrict the outflow of currency.
The health of a country’s current account is also influential. If a country has a balance of payments deficit, then it needs to sell its own currency to buy foreign currency and pay payments deficit of the country. Doing this reduces the exchange rate because imports became more expensive and so less desirable.
Among the factors that affect the exchange rate is the level of public debt is a big influencer on exchange rates. Many countries have racked up huge debts and have trouble servicing them. This adds to uncertainty over whether a country will default, reducing inward investment as the likelihood of the investor getting his money back decreases. Debt can be acquired domestically but if it is insufficient they need to look at foreign investment; selling bonds to foreigners and reducing prices of these bonds to make them more attractive, and so decreasing the exchange rate.
A government can also increase the money supply, simply by issuing treasury bonds, recently seen in the USA as the quantitative easing. This can have an adverse effect on the exchange rate as it can increase inflation and making it more expensive to buy goods and services, which will decrease the demand for those goods and services, and so decrease the value of the currency.
Variances in the terms of a country’s trade also has an effect. If a country’s exports are in great demand, so the amount of the currency purchased will also increases, then the country’s currency’s price will increases, further helping the economy to improve and stabilize, which is what happened with the Australian dollar in 2008-2009 when it doubled its’ price. The converse is also true.
Finally, political stability can influence the exchange rate since worried investors will sell the currency if they think that the political process is breaking down.
Those are the factors that affect the exchange rate all traders needs to have knowledge of. Before making a trade, he needs to understand how they have been factored into the exchange rate. The ‘sixth sense’ is simply the ability to analyze and predict the change of one or more of those factors, and so gaining a competitive advantage which will increase the probability of successful trades.