Why do forex rates fluctuate?

The exchange rate between two currencies can change considerably throughout the month with some currencies reaching record highs while others dive to all-time lows. This happens because of the constant change in supply and demand which also applies for all goods, services and financial assets.

Why do forex rates fluctuate?

Forex rates refer to the rate you can exchange one currency for another. This rate fluctuates constantly according to supply and demand which in turn can be affected by multiple other factors. Put simply, the more a currency is in demand, the higher its value is going to be – as long as supply remains the same. If there is a surplus in supply and demand also fades, then prices will start to go down.

The rate at which a country’s currency is trading at is also indicative of the country’s economic strength and vice versa. If the U.S economy is doing well – low unemployment numbers, strong exports etc. – then the dollar will be in high demand and subsequently appreciate in value.

Forex currency rates can likewise have a significant impact on the country’s economy as well. A weak currency is more appealing to foreign companies and may increase exports since purchasing goods and materials will be more cost-effective. A perpetually weak currency, however, will have an adverse effect on the economy because, over time, imports will become increasingly cost-prohibitive and foreign investment will also stagnate.

Due to the sensitive relationship between the balance of trade and forex rates today, central banks need to constantly monitor and tweak their monetary policy in order to keep their country’s currency from becoming too strong or too weak leading to inflation or recession respectively.

Forex Rates

What affects forex rates today

As already mentioned, the central banks can change their monetary policy to control how a currency performs by simply increasing or decreasing the interest rates it offers to other commercial banks. Lower interest rates translate to more attractive loans, faster expansion and higher spending for the local industry which promotes economic growth.

On the other hand, when an economy grows too rapidly for its own good and inflation is looming, the central bank can increase its interest rates in order to discourage companies from borrowing capital, decrease spending and slow down growth to manageable levels.

Another key factor that can create a dramatic shift in live forex rates is the local and global political landscape. Developing countries where tensions are high and there’s risk of political instability aren’t considered as attractive to investors who prefer strong economies with stability in the region.  

In fact, the majority of investors are quite risk-averse and will start selling their assets at the first sign of uncertainty causing significant downside spikes in forex rates. This is why forex traders need to stay abreast of any developments in the sociopolitical climate of the countries whose currency they are trading.

Admittedly, forex traders and speculators themselves can influence the performance of a currency. While the forex market is incredibly massive with trillions of dollars in daily trading volume, the combined power of financial institutions and retail traders can create enough momentum to drive forex rates to rise and fall significantly.

An overreaction to a political event can trigger the sell-off of a currency by traders which may spread and proliferate across the forex market which will result in the rapid decline of the currency as well as its exchange rate.

 

Conclusion

Due to the many forces in play that may affect the forex rates between currencies, forex traders need to be extremely cautious. Especially since the forex market is so volatile compared to other more stable markets. While calculated predictions and risks can be taken and might prove profitable in the short term, it’s evident that consistently predicting the market’s direction and the main cause behind the constant fluctuations is virtually impossible.

Foreign investors will always look for the best-performing economies with a strong track record to include in their portfolio and countries that are plagued with social unrest and political uncertainty will not make the list.

Consequently, a successful trading strategy needs to take into account both the fundamental factors that may affect a country’s economic health and the performance of its currency. These may include the GDP, central bank monetary policy and unemployment rates.

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