The foreign exchange (forex) market is dominated by financial/speculative transactions rather than commercial transactions. Of financial transactions, it’s dominated by trades in currencies themselves rather than portfolio flows.
With these two facts in mind, below are the top drivers of the forex market.
Interest rate differentials
Speculation in forex is dominated by the carry trade, which in turn is determined by interest rate differentials.
In carry trades, traders borrow (sell) a low interest rate currency and lend (buy) a high interest rate currency. This allows them to capture the positive interest rate differential. Moreover, the high interest rate currency tends to appreciate against the low interest rate currency in times of global economic expansion.
When interest rates are raised, the underlying currency generally appreciates because it has just become a better candidate for the long (lending) side of the carry trade. (Conversely, if interest rates are raised in a low yielding currency, it has just become a worse candidate for the short side of the carry trade.)
Short-term traders know this. Therefore, if they expect interest rates to be raised for a currency, they will buy and hold it for the short-term. In this regard, interest rate differentials dominate short-term trading.
Historically, the New Zealand dollar carried the highest interest rate among the G10 currencies. Not surprisingly, it was also the most financialized, meaning turnover in the New Zealand dollar is the largest relative to the size of the country’s real economy and trade.
While interest differentials set the tone most of the time, they may not matter at all in special situations.
Back when the world had tradable pegged currencies, the market often attacked pegs it deemed to be unsustainable.
The most famous example was Black Wednesday of 1992, when speculators, led by hedge fund manager George Soros, shorted the pound sterling because they believed the UK could not maintain its currency peg to the Deutsche Mark of Germany.
The Bank of England tried to counteract the short selling by raising interest rates to 12 percent.
However, the pound sterling didn’t budge and England was forced to withdraw from its currency peg and allow the pound sterling to collapse.
On the flip-side, governments can intervene in the forex market.
Sometimes, interventions are unsuccessful and fundamentals prevail. Other times, they successfully override fundamentals (like interest rate differentials) and set the direction for the forex market.
Portfolio flows is the second major reason for financial transactions in currencies.
It refers to converting to a currency in order to invest in the financial assets of the country.
For example, if a Japanese investor wants to buy US equities, he must first convert his yen to the dollar.
Therefore, when the equities or fixed-income market of a country becomes attractive to foreigners, its currency generally appreciates.
(On a related note, fixed-income prices are influenced by interest rates, so again it goes back to interest rate differentials.)
The turnover in the trade of goods and services is smaller compared to portfolio flows, but it’s nevertheless significant.
When a country’s trade surplus widens, its currency tends to appreciate. Conversely, when the surplus shrinks or if the trade deficit widens, its currency tends to depreciate.
Occasionally, a multi-billion dollar mergers and acquisitions (M&A) deal can drive the forex market in the short-term. For example, if an American company wants to buy an Australian company, it must first convert billions of US dollars into Australian dollars, thereby giving a temporary boost to the Australian dollar.
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