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Introduction to fundamentals driving forex pairs

When most people think of trading, they think of stocks or perhaps commodities or maybe even cryptocurrencies. What they may not realise, however, is that there is a market that dwarfs them all and, in fact, if they’ve ever travelled internationally or bought something from overseas they’ve already interacted with it.

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We’re talking, of course, about foreign exchange markets, where an estimated $5 trillion is traded on a daily basis. For a new trader, however, there’s a lot to take in, including the macro-economic and geo-political factors that help drive movements in currency pairs.

What is a currency pair?

A currency pair or forex pair is simply the quotation of the value of a given currency against another. The first is termed the base currency and is the currency being sold, while the second is known as the quote currency and is the currency being bought.

For example, the quotation EUR/USD = 1.3500 would mean €1 is exchanged for $US1.35.

Factors that affect forex pairs

One part of becoming a successful trader is developing an understanding of the fundamentals that drive both markets and individual assets. This is the information that will help you to establish an informed hypothesis about whether a particular stock or commodity, or an entire index for that matter, is being fairly valued at present and what the potential upsides or downsides might be from here. These include:

  • Interest rates

Interest rates have a significant impact on currency movements and it's common to see a notable spike or fall in a currency pair following central bank announcements.
The main reason for this is the so-called carry trade, where investors borrow at lower interest rates in one currency and invest at higher interest rates in another.

In the current low global interest rate environment, even relatively small differences can be enough to attract investors.

  • Inflation

One of the major reasons central banks set interest rates is to control inflation. Therefore, movements in a country’s inflation rate can impact currency pairs. For instance, if a country’s central bank believes prices are going up too quickly, it may lift interest rates to lift the cost of borrowing and slow the economy a little bit.

For this reason, national inflation data is one of the most closely watched pieces of information for forex traders.

  • Economic growth

Once again, this relates to interest rates. When a country’s economy is growing quickly, the rate of inflation typically starts to creep up, which means the central bank may need to lift interest rates.

For that reason, positive economic data may see that country’s currency appreciate against those of other countries, while negative data may see it slide, though there are always a number of factors at play.

  • Trade data

Trade data can be important to foreign exchange markets for a few reasons. If a country is exporting more goods than it imports that increases demand for its currency as the money used to pay for those exports ultimately needs to be converted into the local unit.

Trade figures can also be seen by some as a sign of the strength of the economy, which in turn has implications for inflation and interest rates, and therefore the currency.

  • Political/government factors

In most developed nations, governments have handed over control of interest rate policy to independent central banks to de-politicise decision making. However, government policy can have profound implications for inflation.

For instance, a government that decides to cut spending and pay down debt may end up causing the economy to slow while one that increases government spending may stimulate growth and cause prices to rise.

Do different forex pairs move in similar directions?

Foreign exchange markets are extremely complex, but it has been noted that some pairs tend to move in similar directions. Here are a few well know ones:

  • Euro and Great British Pound
    • There has been a well-documented correlation between the EUR/USD and GBP/USD pairs, which means that when the US Dollar is moving higher (or lower) against the Euro it is usually moving higher (or lower) against the Great British Pound as well.
  • Swiss Franc and Japanese Yen
    • Both the Swiss Franc (CHF) and Japanese Yen (JPY) are generally considered “safe haven” currencies, meaning investors tend to shift their money towards them when there are concerns about the global economy. As a result, they often tend to move in similar directions against the US Dollar.
  • Commodity Currencies
    • The Australian, New Zealand and Canadian Dollars and the Norwegian Krone are often grouped together as “commodity currencies” because of the importance of commodity exports to their respective economies. Since commodity prices tend to move higher when the global economy is doing well these currencies are often seen to move in similar directions.

What Else Affects Forex Pairs?

Although economic data and other news items play a major role in influencing currency, it’s important to note that an estimated 90% of daily forex volume is generated by speculators (traders). This means technical analysis plays a critical role alongside fundamentals like interest rate settings and trade figures. For more information on the technical factors influencing currency markets, visit out Learn Forex page.

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