Floating Exchange Rates | Merchandise Trade Balance
Flow of Funds | Yield Differentials | Rate of Inflation
Fundamental & Technical Analysis

Many economic factors affect the FX market. Here are some examples of the ones that will most likely affect you.

Floating Exchange Rates - Technical Analysis

The Merchandise Trade Balance
One factor affecting the exchange rate between currencies is the merchandise trade balance. This is the net difference between the value of merchandise being exported and imported into a particular country. For example, the net difference between the Canadian demand for US dollars to buy American merchandise, and the supply of Canadian dollars affected by the Americans' purchase of Canadian merchandise, is the merchandise trade balance between the two countries.

Flow of funds to pay for stocks and bonds
The flow of funds between countries to pay for stocks and bonds also affects the currency exchange rate between countries. However, in the near term, capital flows are greatly influenced by yield differentials.

Yield differentials and their affect on currency values.
Yield differentials is the difference between interest rates in various countries and how it affects currency values. As an example, let's use German and American securities to illustrate how interest rates affect exchange rates.

All else being equal it stands to reason that a higher yield on German securities (compared to American securities) would make German securities more attractive. What's more, an increase in German yields would raise the flow of U.S. dollars into German securities, and decrease the outflow of Deutsche marks to American securities. This increased flow of funds into Germany would lower the value of the U.S. dollar and increase the value of the Deutsche mark. Hence, the Deutsche mark to U.S. dollar ratio, as it is represented in the foreign exchange market, would potentially decrease.

Rate of inflation
Consumers try to avoid the eroding effect inflation has on their purchasing power. Consequently, goods from countries with a low inflation rate become more attractive than the goods from countries with higher inflation. In turn, the currency from the lower inflation country rises in value, while the currency from the higher inflation country falls in value. Both the inflation factor and the purchasing power of the currencies directly impact currency exchange rates. For example, if the United States is experiencing lower inflation than its trading partner Germany, the DM/USD ratio would rise to reflect the growing price level in Germany relative to the United States. This factor is rooted in the concept of purchasing power parity. It holds that, over the long run, a currency exchange rate adjusts to reflect the difference in price levels between countries.

Fundamental and Technical Analysis

Fundamental Analysis tries to understand price moves in the market by analyzing the economic factors that can affect the price of a particular financial instrument, in this case, currencies. Importance is placed on interest rates, trade balance, government policies, market supply and demand, and a myriad of other factors that can affect the intrinsic value of a currency against another currency.

Technical Analysis, on the other hand, states that all the factors whether it be economic, political, or even the effect of weather on the value (or price) of a currency is all factored into the 'market price' of a currency. It is therefore only necessary to study the technical charts, which show all the effects, and all the causes that a "fundamentalist" would study. Thus the study of price movement is of primary importance to a "Technician" to determine where the markets are going.

In reality, both factors are important in determining the value of buying and selling currencies. Whichever school of thought you adhere to, the fact remains that when the perceived value of a currency is over-priced it will be sold, if the perceived value is under-priced it will be bought. If there are more 'sellers' in the marketplace, the price will go down. If there are more 'buyers' than 'sellers' the price will go up.

Cambridge Mercantile's forex experts work hard to keep you informed. We carry out technical analysis while continually staying on top of all relevant FX news.