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5 Key Factors Affecting the Forex Market

1. Central bank interest rates

When the central bank raises interest rates, this proves that the national economy is going strong and the central bank is optimistic about the economic outlook. But when the central bank cuts interest rates, it means that there are underlying issues with the national economy and the central bank is pessimistic about the economic outlook.

From a macro perspective, the central bank and its interest rate policy greatly impact the forex market.

Indeed, the above statement oversimplifies the economy, but the following is generally how the central bank reacts to economic changes.

When traders believe that interest rates will rise, they will usually buy the currency before the central bank issues an upward adjustment policy. If they think the interest rates will decline, then they will do the opposite. However, if the trader’s prediction is inaccurate, it can lead to catastrophic consequences. So when traders try to predict the direction of the central bank’s interest rate policy, things get complicated.

Since the recession in 2008, most of the world’s major central banks have formulated management policies, paying more attention to the effective signals of short-term target markets. When the central bank releases a clear-cut interest rate increase signal, it is usually a good time to buy the currency.

2. Central bank intervention

When the currency fluctuation’s negative impact on the economy exceeds a certain limit, the central bank will intervene and even define the exchange rate.

For instance, the appreciation of Yen is extremely unfavourable to Japan, a country where the economy depends heavily on exports. Take the price of a DVD player as an example to illustrate the impact of Yen’s value on general trade:

USD/JPY EXCHANGE RATE DVD PLAYER PRICE (USD) DVD PLAYER MANUFACTURER INCOME LOAN (JPY)
80 US$100 JPY8,000
100 US$100 JPY8,000
120 US$100 JPY8,000

For Japanese exporters, the USD/JPY exchange rate of 120 is far better than 80. In the first case, selling the same amount of products allow them to earn higher sales. But if the rate falls, they will need to increase the product’s unit price, which will inevitably affect sales. This is especially obvious when the national currency appreciates. For exporters, this is a catch-22 with no viable solution.  In order to prevent excessive appreciation of currency, the central bank can make the market more liquid by releasing previously frozen funds (reserves) to regulate rates. The increase in market liquidity dilutes the value of the currency, resulting in its depreciation.  It is quite difficult to predict the central bank’s intervention policy. Unlike interest rate regulation, there is usually no pre-emptive news for intervention. Often, the public is informed about the intervention policy only after it is introduced. Despite this, intervention is not completely without trace, especially when the central bank repeatedly declares that its currency value has reached an all-time high, the possibility of its intervention is greatly increased. However, the central bank usually chooses an unexpected time to intervene, so as to avoid public speculations. 

3. Options

In forex options trading, international trade accounts for the highest proportion, that is, companies can hedge against exchange rate fluctuation risks. However, the proportion of speculation in forex trading is rising.

Double No Touch (DNT) options are a specific type of option that FX traders favour the most. Usually placed on rounded figures in popular currency pairs like EUR/USD or USD/JPY, this type of options is often targeted by extremely liquid investors. A currency pair may fluctuate quite a bit and approaches the ideal rate in the trader’s mind, or it may surge beyond that and then falls just as quickly. Other times, the market gets close but never quite settles where investors want it to be.

4. Fear and greed

To put it simply, fear can turn the decline of a financial product into all-out panic and greed can turn a bearish market into a blind-buying spree.

The late 1920s is a great example. People were vying to snap up everything on Wall Street. Greed was at its highest point as the popular belief was that stock prices would continuously rise without falling. Then Black Tuesday hit and panic led to the Great Depression.

The link between the two emotions can go the other way, too. The Eurozone crisis, especially Greece in the 2010s led to the over-selling of EUR as fear dominated mainstream thought. However, greed soon reared its ugly head and drove the currency to levels so detrimental that employment and inflationary dynamics were completely impaired. It came to a point that the European Central Bank had to force devaluation of EUR through various market manipulation techniques.

While it may be easy to see the effects of fear and greed after the event, determining the exact moment when things flipped is the key to preventing history from repeating itself.

5. News

Some news may be foreseeable and some may not. However, both can move the market in extreme ways. Unsurprisingly, investors are more comfortable with foreseeable news as their effects on the market can be forecasted. As for the unexpected ones, there’s nothing much investors can do except to counter it with effective risk management and hope for the best.

Yet, not all foreseeable news/events are market movers. Part of the trader’s job is to recognise the signs prior to a major happening and use it to their trading advantage. For instance, under normal conditions, employment reports from major financial organisations tend to draw a stronger market response compared to a manufacturing sales report; and a retail sales figure shakes things up more than a currency supply report.

While not all major news such as a Non-farm Payrolls release or a central bank monetary policy will move the market, they have the biggest possibility of doing so. Therefore, knowing when the markets may move can be one of the greatest advantages you have as a trader.