The exchange rate between countries is far from arbitrary it is based largely on whether or not a country is attractive to outside investments.
For example an increase in a country's domestic interest rates may attract foreign capitals therefore strengthening its currency.
Fundamental and technical analysis.
Six key factors are involved in pricing of currencies for predicting where it is headed. Five are considered fundamental factors. The sixth is a technical factor
Fundamental:
- Central bank policy.
- Interest rate differential between countries.
- Economic indicator report which provide information on the underlying state of a country's economy.
- Exchange rate adjustments.
- Market expectations.
Technical:
- Technical analysis.
Central Bank policy.
The first fundamental factor is Central bank policy. The goal of any government's economic policy is to achieve a strong economy characterized by 3 factors.
1- Growth in gross domestic product otherwise known as GDP.
2-Job growth (low unemployed rates)
3- And last but not least stable prices as in ( Inflation percentage)
Two vehicles help a government to achieve these objectives, these are Fiscal policy and Monetary policy.
Fiscal Policy means changes in government spending and taxation. Elected politicians control this.
Monetary Policy. Each government has a Central Bank for example: the US Federal Reserve, the Bank of Canada.
The Central Bank implements monetary policy by influencing short term interest rates. Changes in short term interest rates have a significant impact on the value of a currency.
Central banks have no direct control over longer-term interest rates like bond yields or mortgage rates. But when short-term rates rise or fall, these rates are also affected, along with the stock market and currencies.
Example one.
If the Central Banks lower short-term interest rates, the multiplier effect inherent in borrowing increases the supply of money. With more available money, economic activity should increase.
- More available funds decrease the cost of money.
- Lower rates encourage business and consumers to borrow and spend more.
- Effects on the major markets should be as followed :
The cheaper cost of borrowing encourages spending. this stimulates growth.
Older bonds with higher rates are now more attrative to investors. The demand for bonds increases.
Lower costs of borrowing lead to increased corporate profits and growth. The demand for stocks increases
As exchange rates drop, foreign investors sell domestic securities, moving their money to higher yielding currencies.
The price of a specific currency goes down.
Example two.
If the Central Bank raise short-term interest rates, the money supply shrinks.
Economic activity should decrease.
-Fewer available funds increase the cost of money.
-Higher rates discourage business and consumers from more borrowing and spending.
-Effects on the major markets should be as follow.
Bonds at lower rates are less attractive to investors. Bond prices fall and long-term interest rates rise.
Higher costs of borrowing lead to decreased corporate profits and growth. Demand for stocks decreases. As interest rates increase. foreign investors demand for domestic securities increases. Because they must pay for these domestic securities, the currency value increases.
Stay tuned for my next article about how a Central Bank determine whether to raise interest rates.
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