4.2 Factors influencing exchange rates

Exchange rates are influenced by a complex interplay of economic factors, political events, market sentiment, and central bank actions. These elements shape currency valuations, impacting international trade, investment flows, and global financial stability.

Understanding these dynamics is crucial for navigating the forex market. From inflation and interest rates to political stability and central bank policies, each factor plays a role in determining currency strength and exchange rate movements.

Economic Factors and Market Dynamics

Economic factors in exchange rates

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• Inflation erodes currency value as higher rates typically lead to depreciation, explained by purchasing power parity theory comparing relative inflation between nations

• Interest rates attract foreign capital when higher strengthening currency, influenced by differentials between countries and real interest rate considerations

• Economic growth boosts currency through stronger GDP growth rates, improved employment figures, and increased industrial production

• Trade balance impacts currency strength with surplus typically strengthening it, reflected in current account balance and export competitiveness

• Government debt may weaken currency if levels are high, often measured by debt-to-GDP ratio

Political events and currency values

• Elections create uncertainty impacting currency, potential policy shifts affect valuation (US presidential elections)

• Policy changes like fiscal adjustments or foreign investment regulations influence exchange rates (tax reforms)

• International conflicts including wars, sanctions, trade disputes destabilize currencies (Russia-Ukraine conflict)

• Political stability affects foreign direct investment and long-term currency valuation (emerging market political risks)

• Regional integration or disintegration shifts currency dynamics (Brexit impact on GBP, Eurozone developments on EUR)

Market sentiment in rate fluctuations

• Risk appetite drives currency movements in risk-on vs. risk-off environments, affecting safe-haven currencies (USD, JPY, CHF)

• Speculative positioning in futures markets and carry trade dynamics influence short-term fluctuations

• Technical analysis using support/resistance levels and trend following impacts trader behavior

• Economic data releases cause market reactions based on surprise factor relative to expectations (NFP, GDP, CPI reports)

• Global financial market conditions including equity performance and commodity prices affect currency movements

Central bank influence on rates

• Interest rate decisions impact currency valuation through rate hikes/cuts and forward guidance (Fed funds rate)

• Quantitative easing and tightening affect currency supply through asset purchase programs and balance sheet adjustments

• Foreign exchange interventions involve direct buying/selling of currencies or verbal "jawboning" to influence rates

• Currency pegs and managed float systems require central bank defense of values, occasional realignment (CNY/USD peg)

• International coordination through G7 or G20 interventions addresses competitive devaluation concerns