Who trades currency markets?
Central Banks
Banks, investment banks, financial firms and swap dealers
Multinational Corporations
Asset Managers
Hedge Funds, commodity funds and other leveraged funds
Retail traders and individuals
Most commonly traded currencies
Influences and behavior of currency makets
Forex trends tend to be long and sustained
Sensitive to changes in fiscal, monetary and trade policy
Highly influenced by sentiment and investor psychology
Can be event driven at times
Forex trends reflect many different types of “macro” scenarios and can also be used as a proxy to construct nearly any economic scenario
What drives currency exchange rates?
Interest rates (monetary policy)
Fiscal policy (fiscal balances, taxes, etc.)
Sentiment (bullish, bearish)
Balance of Payments (trade balances)
Speculation
Geopolitics (war, disputes, political changes)
The price of oil
Purchasing Power Parity
Belief vs Truth: Interest rates
Belief: High interest rates make a currency stronger, low interest rates weaken a currency.
Truth: Likely the opposite.
High rates equate to larger fiscal injections (“money printing”) whereas low interest rates remove the currency via the interest income channel.
Fiscal balance
Fiscal deficits increase the net supply of financial assets denominated in the currency. In general the belief is that budget deficits weakens the currency. Expanding deficits equate to increased "money printing" and are therefore bearish for the currency.
In contrast, surpluses are generally viewed as virtuous, but more importantly, surpluses remove income and savings denominated in that currency. Furthermore, since the public still must pay taxes and desires to save, it can create “shortages” of that currency and therefore usually results in a bullish effect.
Currency and Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners.
Current account balances
If a country has a large current account deficit it means it is importing more goods and services than it is exporting and paying out more in financial transfers than it is receiving. This generally leads to pressure on the currency as the rest of the world holdings are hedged via forward sales.
Vice-versa for countries that run current account surpluses. This process can play out over a long period of time. At any given time, however, a country with a trade deficit can see its currency rise and vice-versa.
Purchasing Power Parity
A theory which states that the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent. In short, what this means is that a bundle of goods should cost the same in Canada and the United States once you take the exchange rate into account.
Learn more...purchase my 30-hour video course!
