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In this article, we’ll explore what drives currencies at a fundamental level.
We’ll look at the top G10 currencies in the Forex market.
And explain why these fundamental drivers cause currencies to move.
Understanding these drivers will improve your trading success.
First, let’s talk money.
A Brief History Of Money And Currency
Money has been part of human history for over 3,000 years.
According to Wikipedia, money is any item accepted as payment for goods and services. It is a medium of exchange widely accepted as payment.
The International Monetary Fund (IMF) says money must serve three main functions:
- any object that can be stored and used for later purchases.
- any object that has a unit of value.
- any object that can be used as a medium of exchange.
Money that has intrinsic value. And money that does not have intrinsic value. These are two main types of accepted money.
Money with intrinsic value is commodity money.
Intrinsic value means it has value outside of its use as money. For example, commodities such as gold and silver have been used to make various items since 6,000 BC.
Thus, the value of gold and silver is defined by the value of the commodities themselves.
Commodity money is the simplest and one of the oldest types of money. It is based on the old bartering payment system.
Before ‘money’, cattle were used to barter. But, there was no proper value equivalence to the exchanges. This presented various problems.
Cowrie shells were in use well into the 20th century. They are the prehistoric predecessor to diamonds and gold.
Commodity money finally evolved into the form we recognize today. Gold.
But, Franklin Roosevelt secretly ended the gold standard in 1933. His policy prohibited US citizens from converting US currency into gold.
The US Treasury was still allowed to convert dollars into gold for foreign governments. They did this to maintain stability and confidence in the US dollar.
The United States closed the gold standard window in 1971.
Old commodity money has its place in history. But it also presented some disadvantages:
The value of the commodity could fluctuate erratically. Especially during times of economic or political unrest.
The quality could vary and some commodities were perishable. For example, wheat.
The logistics of carrying the commodity money around presented a problem. Try carrying bars of gold or sheaths of wheat in your pocket!
Furthermore, dividing the commodity into smaller denominations was also an issue.
Based on what we’ve learned so far, it’s clear that money has had a long history.
It’s also clear that ‘money’ is ultimately defined by what other people accept.
This brings us on to money without intrinsic value.
Money without intrinsic value is fiat currency or fiat money.
This is money that has no value outside of its use as money.
This type of money is legal tender. Its value is backed by the government that issued it.
A government decrees that a particular currency has value. And it can be used as payment for goods and services in that country.
Since the 1970’s every country has been using fiat currencies as a monetary system.
Take a look inside your wallet or purse. You’ll generally see a currency with different denominations.
We’ve covered a brief history of commodity money and fiat currency. And have also explained their differences.
We’ll now focus on currency.
What Determines The Value Of A Currency
All fiat currencies are created out of nothing. Who decides its value?
So, the value of a currency is determined by the demand for it.
For example, the British pound is over 1,200 years old. It’s also the world’s oldest currency that is still in circulation. Yet, it is only the fourth most traded currency in FX.
Whereas the US dollar is involved in 88% of all trades in the FX markets.
This makes the US dollar the most traded currency in the world. It also exemplifies demand.
Fiat currency is not backed by any physical commodity. It still has the potential to be rendered worthless due to hyperinflation.
If people lose belief in a nation’s currency, the currency will no longer hold any value.
This is why a currency’s value is underpinned by the strength and credibility of its government.
The three main universal benchmarks that help determine the value of currencies are:
- Interest rates. High interest rates usually help build a strong currency
- Economic policies. Certain economic policies can help strengthen a currency
- Stability. The more stable an economy, the stronger its currency
Note: there are always exceptions to these benchmarks.
Other factors such as the rise and fall of an economy can also affect the value of a currency.
Fundamental Drivers Explained
The G10 currencies of the Forex World are:
- US dollar (USD)
- Euro (EUR)
- Japanese Yen (JPY)
- British pound (GBP)
- Swiss Franc (CHF)
- Canadian dollar (CAD)
- Australian dollar (AUD)
- New Zealand dollar (NZD)
- Norwegian Krone (NOK)
- Swedish Krona (SEK)
We’ll discuss the key fundamentals that drive them based on two main categories:
- Drivers common to all G10 currencies
- Drivers specific to certain currencies
Common Fundamentals Affecting Currencies
Remember that two reasons driving the FX market are sentiment and fundamentals.
Fundamentals are underlying factors that don’t change very often or change slowly.
Sentiment is a market’s ‘mood’.
This market mood can change many times during a trading session. It can sometimes be contrary to the direction of the underlying fundamentals.
Below are the common fundamental drivers amongst the G10.
Changes in these fundamentals will cause currencies to either appreciate or depreciate.
￼The easiest way to think about interest rates is as the ‘price of money.’
Interest is the cost of borrowing money. It is also what banks pay you for saving money with them.
Changes in interest rates is one of the fundamental drivers of currencies in the FX world.
There are various reasons why the interest rates of a country may change:
Central Banks alter interest rates to manage the economy and control Inflation.
When a central bank loosens monetary policy, it is ‘creating more money.’
This is because it becomes cheaper to borrow money.
This is because it becomes more expensive to borrow money.
It’s important to note here that other central banks’ policies can also impact their peers.
And neighbouring currencies sometimes move in tandem. E.g. A depreciating AUD may drag the NZD down.
An economy is growing when there is an increase in the amount and value of goods and services over time.
The ONS provides a definition of Gross Domestic Product (GDP). It describes it as ‘an estimate of the total value of goods and service produced by a country.’
GDP is a subsidiary of economic growth.
Higher potential economic growth affects real interest rates in two key ways:
- It increases returns on investment. This leads to higher investment demand.
- Higher growth boosts future household earnings. This encourages consumers to buy more and save less.
If the combination of the two fuels economic growth, it increases inflation. This causes central banks to take action.
In this case, their action would result in an interest rate hike. And as we see in the image above, traders anticipate this and will buy the currency.
Economic indicators reflect how a country is performing.
Internal and external macroeconomics have a big impact on a currency’s direction.
We’ve already mentioned two fundamental drivers above. Other economic drivers include:
They are forward-looking indicators to gauge an economy’s performance.
CPI measures the change in prices of goods and services from the buyer’s perspective.
PPI measures the change in prices of goods and services from the seller’s perspective.
CPI is the most used measure of domestic inflation. But, PPI is also used as a preview of changes in the rate of inflation.
When analysing these data points, it is the core data that is generally of significance. This is because core CPI and core PPI exclude volatile data such as food and energy prices.
As we’ve discussed above, if inflation is too high or too low, it causes central banks to take action.
Inflation that rises too sharply is a problem. According to FocusEconomics, the 2018 inflation forecast for Venezuela is estimated to reach 4,128%!
Awareness of current inflation levels is a key aspect of fundamental analysis.
This helps traders plan ahead and anticipate a central bank’s next move.
This is a strong economic indicator because it shows the level of unemployment in a country. It gives a sign of the direction an economy is heading.
High unemployment is a strain on any economy. It’s seen as a weak economy with slow growth and little spending. This may prompt the central bank to boost the economy.
But, rising employment in a growing economy could spark fears of high inflation. This may prompt the central bank to hike interest rates to stop the economy over-heating.
Governments generally aim for unemployment of 1-2% of the total workforce. This does not include underemployment.
To get jobs data, the US Bureau of Labour Statistics (BLS) carries out surveys every month. They have been doing this every month since 1940.
Wages are another key fundamental factor to economic health. It works in tandem with inflation.
Rising wages mean consumers have increased purchasing power. It also means an increase in living standards.
If households have more disposable income, they buy more luxury goods.
This prompts companies to increase production of goods. And to increase production, they may employ more staff.
When an economy reaches full employment, companies pay higher wages to attract staff.
Thus, the cycle of wage growth continues.
Real wage growth generally corresponds with very low unemployment.
Higher real wages have a positive effect on an economy. The more households earn, the more tax they pay. Companies also pay more VAT.
These combined factors lead to less government borrowing.
Rising real wages that stem from increased productivity are good for an economy.
Real wage growth = nominal wage growth – inflation.
Real wage inflation becomes an issue if it is financed by increasing the price of goods. And if it eats into a company’s profit margins. This is unsustainable for a company.
A combination of changes in wages, earnings and productivity growth can move currencies.
Retails Sales measures the consumer’s demand for finished goods in an economy.
It’s a leading indicator and feeds into an economy’s GDP.
This data point indicates whether an economy is expanding or contracting.
As with CPI and PPI, it’s the core retail sales data that is important. Core retail sales excludes high-priced auto sales because the data can be volatile.
As we’ve seen before, the health of an economy is pivotal to the strength of its currency.
Purchasing Managers’ Index (PMI)
￼PMI indicates the economic health of the manufacturing and service sectors.
This economic data point provides information about changes in current business conditions. It provides this information to decision makers and purchasing managers.
US PMI data is compiled monthly by the Institute of Supply Management (ISM).
The data collates information on five key areas. New orders, inventory levels, production, supplier deliveries and employment.
The data is scored from 0 to 100. Above 50 means expansion and below means contraction.
This data assesses whether conditions are improving, stagnating or getting worse.
This information helps businesses plan. And can help with their annual budgets.
For example, some businesses make future production decisions. These decisions are based on the expectation of future customer orders.
If business conditions are improving they’ll buy resources in anticipation of future sales.
Furthermore, companies are likely to hire more staff. This will benefit the economy by reducing unemployment.
If business conditions are getting worse, e.g. a manufacturer’s new orders are declining. A manufacturer may have to lower the price of its goods.
The business may also reduce its workforce.
This will have a knock-on impact to the economy and increase unemployment.
Consumer Confidence Index (CCI) and Business Confidence Index (BCI)
￼￼CCI and BCI are fundamental indicators for consumers and businesses.
Consumers’ confidence is based on their future prospects of household consumption and savings. It also covers financial situation, employment and feelings about the general economy.
Like some aspects in PMI, BCI is used to assess the optimism of businesses.
Watching the trends of these indicators can help forecast a turning point in an economy.
These are two more important fundamental drivers of currencies.
Their names are sometimes used interchangeably.
An economy’s current account deficit is a broad measure. It includes its trade balance deficit and also balance of payments.
Both current account and trade balance deficits shows the health of an economy. This is in relation to an economy’s trade and transactions.
Sometimes, the value of an economy’s imported goods and services exceeds the value it exports. It is said to have a trade deficit.
This is generally bad for an economy as it must buy more goods from abroad. This also means the economy has to borrow foreign currency to cover the balance.
Usually, a country with a large trade deficit will have a weak currency.
But, this is not always the case. An SCMP article shows the United States as an exception to this rule.
According to the U.S. BEA, US deficit has been increasing since 2016, hitting its highest level in 2018.
Yet in 2018, the US dollar continues to be one of the strongest amongst its peers.
Because the US economy is strong on all other economic fronts.
Furthermore, the US dollar acts as the world’s reserve currency.
As long as the US dollar plays a major role in global trade, it will continue to be in demand.
This in turn, will limit the impact of its deficits. For now.
There are also economies that run a big trade surplus, e.g. Germany and China. This means they are exporting more than they import.
If you’ve been listening to FX news you’ve probably heard the term ‘trade wars’.
It’s important to note the fundamentals mentioned thus far are by no means the only drivers of a currency. But they are the main ones.
It’s also important to realise that their impact depends on the country’s economic cycle.
The main focus of the FX market at that time will also have a deciding factor which way a currency moves.
Specific Fundamental Drivers
This category of fundamental drivers is only specific to some G10 currencies.
We’ll look at these now.
This is not the same as ‘commodity money’ we learned about earlier on. These are currencies where price is correlated with the major export of that country.
The following are the commodity currencies in the G10 with their main exports:
- The Australian dollar (AUD) – iron ore, coal, gold, copper
- New Zealand dollar (NZD) – dairy
- Canadian dollar (CAD) – vehicles, crude oil
- Norwegian Krone (NOK) – crude oil and gas
These economies rely heavily on the exports of their commodities. So, if the price of commodities fluctuates, it tends to impact the correlated currency.
Remember that global trade is done in US dollars. This means a rising US dollar makes it more expensive to buy these commodities.
Commodity currencies are then affected two-fold:
– The US dollar is appreciating against the commodity currency.
– An appreciating US dollar also makes buying the commodities more expensive.
Both factors will cause the commodity currency and the commodity prices to fall.
The above works in reverse if the US dollar were to weaken.
The Financial Times explains carry trades.
They define them as borrowing or selling a financial instrument with a low interest rate. And using it to buy a financial instrument with a higher interest rate.
An example of this could be to buy the US dollar against the Swiss Franc.
The US currently has the highest interest rate amongst the G10 at 2.25%.
Switzerland has the lowest interest rates amongst the G10 at -0.75%.
According to Forexop, this means you would be getting paid simply to hold this trade.
Buying Australian dollars and New Zealand dollars are also popular carry trade choices.
Carry trades are used as a trading strategy. This causes fundamentally weak currencies to appreciate despite poor economic indicators.
Safe havens are currencies that investors buy and hold during market uncertainty.
You’ve probably heard of the terms ‘risk on’ and ‘risk off’. As explained by Bloomberg, these terms describe global market sentiment.
When global markets are in turmoil or uncertain we see risk off sentiment pervade the market.
During risk off, investors take their money out of risky assets. They then put them into what they perceive as lower risk assets. This is called safe haven flows.
When global markets are no longer in turmoil, we see risk on sentiment.
Investors put their money back into riskier assets such as the stock market.
The traditional safe havens are:
- Japanese Yen
- Swiss Franc
- US dollar
The situation that causes the risk off sentiment may determine which safe havens are used.
This doesn’t always mean investors will chose a safe haven that is far away from the cause of risk.
Flows into the Japanese Yen during the North Korea missile tests is an example. Japan and North Korea are in the same geographical region. Yet investors used the JPY as a safe haven.
Trade wars with the US and China are another example.
The US started the recent trade wars tensions. So, you would assume investors would take money out of the US dollar.
Not so, as a BNNBloomberg article explains.
It depends what else these safe haven economies have going for them.In this case, the United States has a strong economy and tightening monetary policy.
Japanese investors hold a lot of assets in foreign markets.
This means when they are risk averse they sell the foreign assets. They then repatriate the money back to Japan and into their local currency.
When investors pour money into any of these safe havens, the currency appreciates.
Thus, safe haven flows can also cause currencies with poor economic data to rise rapidly.
We’ve now covered the key fundamental drivers of the G10 currencies.
It’s important to briefly mention some other factors that are equally important. Because these can move currency prices in a big way.
External and Inter-Related Drivers
Although not an economic fundamental driver, politics can have major impact on currencies.
Be aware of upcoming political news. Then decide how it can affect the currencies you are trading.
Stock Market, Bonds and Yields
The stock market, bond market and yields can also drive currency movements.
Babypips explains the correlation between the stock market and FX. We have already seen how global market sentiment can cause safe have flows.
The government bond market is an important area for FX traders.
A bond is simply a type of loan. It’s known as fixed-income securities. This is because the profit you make at the end of the loan is known in advance.
Governments issue bonds as a way to help with account deficits and to control money supply.
Government bond yield is a return on investment. It is expressed as a percentage.
Bond yields are affected by the interest rates of its country.
Higher interest rates means lower bond prices.
A rising bond yield is a bullish currency. A falling bond yield is a bearish currency.
Bond yields can also act as an indicator. They highlight the future direction of the country’s interest rates and expectations.
For example, when trading US dollars you would focus on the 10-year Treasury notes.
A Think.ING article explains the February 2018 sell off in the bond market.
Bonds and yields need a whole other article. For this article, it’s relevant to briefly show how they affect FX. And vice versa.
Increasing Your Trading Success Rate
We now understand the key fundamental factors that can drive a currency.
How can you use this to your trading advantage?
Next, make notes about the fundamental strengths or weaknesses of each economy. Use this to assess the expected longer-term direction of those economies.
Once you have a list, decide what monetary policy tools a central bank is likely put into place.
You have now increased your chances of successful trades.
Let’s look at an example of a fundamental economic driver in action.
Example – Interest Rate Hike
The Bank of England raised interest rates on 2 November 2017. They did this because inflation had reached a five year high of 3%.
Inflation had moved above their 2% target. They were worried about the UK economy over-heating.
This was the BoE’s first rate hike in 10 years.
It was a big deal.
The chart below shows the outcome of their monetary policy move. The rate hike.
The British pound strengthened against the US dollar. It gained over 1,200 pips in 3 months!
And this was despite the UK being in political turmoil due to Brexit.
In this article, we covered the key fundamental drivers of the G10 currencies. And explained why they moved.
We also looked at a brief history of money. As well as the difference between commodity money and fiat currency.
We then provided practical steps you could take to increase your trading success.
Finally, we showed an example of how a fundamental driver actually caused a currency to move.
Always remember there may be more than one factor influencing a currency at the same time.
And a currency does not always immediately move in the direction of its fundamentals.
Price will eventually trend back in line with the overall fundamentals.
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