The foreign exchange market is the largest over-the-counter (OTC) global marketplace that determines the exchange rate for major, minor, and exotic currencies around the world. Every day, nearly $7.5 trillion is exchanged between financial institutions, central banks, and independent investors.
As a beginner, what makes the foreign exchange market so volatile is incredibly difficult. Between inflation and economic news, there are numerous factors making currency pairs go up and down. Here’s a beginner-friendly breakdown of four critical factors.
1. Inflation
This one is pretty obvious. Inflation has a direct impact on a country’s currency, which brings shockwaves to the foreign exchange market.
When inflation increases, the purchasing power of a country’s currency goes down. This makes the said currency less desirable in the eyes of investors and traders. High inflation also creates uncertainty in the entire market. Participants might try to panic sell, and foreign investment might be discouraged. On the flip side, low inflation attracts foreign capital and encourages traders to buy in.
2. Interest Rate
Along the same lines, interest is directly related to inflation. If inflation rises, a country’s central bank raises interest rates to cool down the economy and prevent a sudden crash. When inflation is low, they may lower interest rates to stimulate growth and meet certain pre-determined inflation rates.
When a country’s central bank raises interest rates, the currency of that country becomes more attractive. Foreign exchange participants might want to deposit their money to earn higher returns. For instance, from 2022-23, inflation surged in the United States. As a result, the U.S. Federal Reserve raised interest rates. This strengthened the US dollar against many other major currencies.
3. Political News
Global events, especially political ones, have a huge impact on currency rates. They can lead to sudden and extremely volatile movement, incurring both profits and losses for participants. Common political events that can impact forex trading are elections, sudden leadership changes, geopolitical tensions and conflicts, trade agreements and trade disputes between countries.
During the recent US-China trade war, which began in 2018, the U.S. government imposed heavy tariffs on Chinese goods, which led to retaliatory tariffs from China. Both USD and CNY suffered volatility, but in different ways. The CNY depreciated, while the USD strengthened. The USD emerged as a safe-haven currency and gained the attention of foreign investors.
4. Market Sentiment
Market sentiment is another dominant factor impacting the foreign exchange market and currency prices. It is a snapshot of the overall attitude of investors towards a specific currency pair. During market changes, investors are optimistic (bullish) or fearful (bearish).
Market sentiment is affected by:
- Economic indicators like inflation news or GDP growth
- News and media coverage
- Regulatory announcements
- High-profile endorsements
- Social media buzz, such as spikes in search trends or hashtags
Remember that successful traders gradually learn to recognise sentiment extremes and how to avoid them. They stick to their trading strategies and ensure robust risk management to avoid suffering losses. Working with a reliable prop firm such as Maven Trading can also be helpful. They will help you avoid common pitfalls and earn greater profits.
Conclusion
Understanding what moves the forex exchange market will help you make better trading decisions, as a new prop firm trader. You need to tap into political events and the news. Understanding the economic news not only in your country’s currency but geopolitically will help inform your trades.