Lesson 4: Common Fundamental Factors That Affect Forex Market

If you’re thinking of entering long-term trading, then you must be aware of the fundamental factors that move the market. These fundamentals have a great impact on the overall and long-term strength of major currencies.

Before you position yourself, ensure that it can withstand the market movements due to these fundamentals. Here are the common fundamentals you must be aware of: 

Lesson Highlights

• The economy of its host country significantly impacts the value of the currency. A negative economic outlook may result in a depreciating currency. A positive economic outlook is likely to appreciate the currency.
• Aside from the economic outlook, the trade flow/balance, capital flow, and the government are also important fundamentals in the forex market.

Factor #1. Economic Growth and Economic Outlook 

Forex trading involves buying and selling of what? Currencies, right? And what factor do you think drives the value of currencies? It’s the economy of its host currency! 

So, when monitoring the economic health (the growth and outlook) of the country, your primary material should be the economic events and new releases of the country. These events attract or deter international investors, multibank interactions, and overall currency transactions – making the economy of the country strengthen or weaken.  

Essentially, when economic health strengthens the value of the currency is likely to appreciate. Likewise, if it weakens, you can expect its value to decline. 

Economy Comparison: The Good and The Bad 

Both positive and negative economic outlooks can have a direct effect on the currency markets.  

When investors, whether individuals, institutions, or big companies, transact with the one’s economy, it will bring positive effects to that economy. Meanwhile, when these market entities deter from transacting from the said economy, it costs the economy to progress negatively.  

Why? 

A healthy economy creates a smooth-flowing tax revenue for the government, and consequently causes the economy to strengthen. An unhealthy economy will steer away transactions, resulting to little-to-no tax revenue. 

With this economic outlook, you can expect the market to be in favor to the currency that economy holds. 

Assume that the US economy is gaining a positive outlook after the Federal Reserve System releases the monetary policy changes of the country.  

With this economic fundamental, many investors, internal banks, and companies will invest in the USD. Consequently, the USD market will appreciate and is likely to strengthen against its currency pair if you trade forex. 

Monetary Policy 

The monetary policy refers to the actions made by a country’s central bank to influence the availability and cost of money and credit to promote a healthy economy.  

It consists of the management of money supply and interest rates. This aims to achieve macroeconomic objectives like controlling inflation, consumption, economic growth, and liquidity.  

As mentioned, monetary policy is made to perform different objectives, and a single monetary policy can’t do the job for all objectives. Here are the two main types of monetary policy and their purpose: 

1. Contractionary Monetary Policy: This aims to reduce the size of money supply. In return, this slows down the growth of its economy. 
2. Expansionary Monetary Policy: This aims to expand the size of the money supply. In return, this makes economic transactions cheaper, promoting speed-up growth. 

Factor #2. Capital Flows 

Capital flows measure the amount of money flowing into and out of a country or economy because of capital investment purchasing and selling.  

With technological advancement, everything has become easier—even investing! With your trading device, a mouse, and an internet connection, you can access the financial market with just a few clicks. Whether that be forex, crypto, stocks, or even commodities.  

When considering the capital flow of the economy, you can keep track of the capital flow balance, which is represented as positive or negative.  

1. A positive capital flow balance suggests that the country has been experiencing an influx of foreign investors while limiting the outbound investment to relatively lower than foreign investments.  
2. A negative capital flow balance is the direct opposite of the latter. Investments made by the locals in other countries are more prominent than the foreign investment coming in.  

When there is a positive capital flow, the currency demand is likely to increase. Why? Foreign investors must sell their currency just to transact the investing currency. This demand entails value appreciation.  

Yes, the simple supply and demand logic! When the supply is high, the demand is weak. When this happens, the currency is likely to lose value. And vice versa.  

Factor #3. Trade Flows and Balance 

By trade, I meant the trade in goods and services between international profiles. Yes, just like what you’ve read in your history book.  

We’re living in a global marketplace. Countries anywhere sell their own goods to countries that want them, which is called exporting. At the same time, that country can also buy the goods they want from another country, which is importing.  

All this buying and selling of goods is accompanied by the exchange of money. Consequently, this changes the currency flow, either into or out of a country.  

But how would you define the trade flow balance? 

1. If the country’s exports are higher than the imports, a trade surplus happens which results in a positive trade balance.  
2. If the country's imports are higher than exports, a trade deficit exists, resulting in a negative trade balance.  

If the trade deficits are evident to the economy, the currency will potentially depreciate. If this happens, it would be best to go short if you use the said currency as the base currency.  

Factor #4. Government: Present and Future 

Due to the Great Financial Crisis, also known as GFC, all investors' eyes become fixated with their respective country’s government.  

For what purpose? 

Well, it’s to see the financial difficulties that the country has been facing. And in the case where there’s indeed a difficulty, an investor can gauge the degree of fiscal responsibility that would end the woes felt in their wallets.  

Essentially, government instability has a direct bearing on economic health. And logically, the health of the economy will likely affect the exchange rate of the currency, consequently affecting the forex market.