Macroeconomic Fundamental Factors
In each country, the Central Bank is responsible for the national currency rate. In his hands are concentrated the tools with which he implements monetary policy. The task of the Central Bank is to maintain an optimal rate that will be beneficial to everyone and will contribute to the development of the economy. For instance:
- The weakening of the euro against the dollar is beneficial to European exporters. After all, they sell goods in the United States for dollars, and they buy raw materials and labor in Europe for euros.
- Strengthening the euro (or a weakening US dollar) is beneficial for importers.
Simply put, the country’s central banks are trying to maintain a balance by all methods, but this does not always work out. Central Bank Tools:
- Emission and foreign exchange intervention.
The entire amount of money in a country is called a money supply. The price of a product indirectly depends on its volume. If the Central Bank uncontrolled issues emissions (puts into circulation even more national currency), but production volumes remain the same, then the price of goods increases. And since the US dollar or the currency of another country can also be called a commodity, the national currency exchange rate falls accordingly.
- The depreciation of the national currency is called inflation. From an economic point of view, moderate inflation contributes to production growth; in the USA and Europe, the target inflation rate is about 2%. Therefore, in countries where high and hyperinflation are observed, the money supply is withdrawn to stabilize the exchange rate. In countries where deflation is observed, negative deposit rates are introduced.
Interesting fact. In 1969, Nobel laureate Milton Friedman proposed a policy of “helicopter money.” In Europe and Japan, deflation has been observed for a long time. Negative rates (when the owner of the deposit pays for the safety of money at the bank) did not solve the problem. Then the idea arose of simply distributing freshly printed money to households. So far, the idea has not been implemented, since there are fears that inflation cannot be dispersed – households will simply save. It is noteworthy that while some countries like Zimbabwe are struggling with hyperinflation, others are not happy with a strong currency exchange rate.
Conclusion: emissions and foreign exchange interventions weaken the national currency against other currencies.
- Balance of payments. The balance between exports and imports directly affects the exchange rate. If the country has a strong preponderance towards imports, this means that to buy goods from other countries you need to spend more foreign currency, while its inflow is absent. As a result, the national currency depreciates. This can be restrained by attracting foreign loans or investors who will help to establish a balance between export and import. Another option to curb imports is to introduce customs duties that will help develop domestic production, and, consequently, strengthen the national currency.
- Gold and foreign exchange reserves. Another tool with which the Central Bank can regulate the money supply. Gold and foreign currency reserves are nominated in gold, foreign currency (which plays into the hands of the US dollar, since most of the reserves are nominated in it), debt securities. If a national currency depreciates and a sharp increase in demand for foreign currency is observed, the Central Bank partially satisfies the demand by selling, for example, dollars to the population, thereby withdrawing surpluses of national money and restraining inflation.
Conclusion: if there is a sharp decrease in gold and foreign exchange reserves in the country, this may indicate that depreciation may soon begin (if the Central Bank is not able to contain inflation).
- Macroeconomic statistics:
- GDP and GNP. The growth of these indicators is a positive indicator on the national currency rate. If GDP is growing, this indicates a positive trend in the country’s economy, which is interesting to investors. The inflow of foreign capital strengthens the national currency. Indicators are considered in dynamics: if the GDP growth for the year is less than the previous similar period, then this is a negative indicator.
- Unemployment rate. Another important indicator of the state of the economy and, accordingly, the rate of the national currency. The lower the unemployment rate, the stronger the national currency. In the United States, the Non-Farm Payrolls indicator (a report on the number of people employed in industries other than seasonal agriculture) is considered the most affecting the dollar after the discount rate, and is estimated along with the average salary.
- Inflation rate. Indirectly, purchasing power affects the exchange rate. The growth of inflation reduces it and thereby negatively affects the exchange rate of the national currency. In countries that are highly dependent on foreign economic activity, the effect of inflation on the exchange rate is especially great, therefore, along with inflation, the consumer price index and other similar statistics are also analyzed.
- Balance of budget revenues and expenses. The budget deficit, covered by additional emissions, increases inflation and leads to a depreciation of the national currency.
- State debt. Let not the most basic, but an important indicator for developing countries. The growth of public debt is a signal to weaken the national currency. The need to service external debt creates excess demand for foreign currency, thereby increasing its value. An increase in the risk of default discourages investors, reducing the volume of foreign currency inflows, creating its deficit. True, there are exceptions to this rule. For example, in the USA.
6. Geopolitics. These include the following factors:
- Elections. A vivid example is the reaction of the US dollar to Trump’s victory. In the fall of 2016, after the US election, the dollar against other currencies rose to 9-year highs. This was aided by investor expectations regarding Trump’s policies. And it is completely justified.
- Trade wars. Example: a trade war between the USA and China. Here the situation is rather ambiguous. Theoretically, trade wars should adversely affect the US dollar (investors prefer calmer assets). But since the US has a fairly isolated economy, the US dollar, on the contrary, strengthened, the renminbi fell to the lows of 2017. This suggests that investors believe that the United States will be the winner in this trade war and, by protecting its own market, will be able to strengthen the economy.
- International sanctions. Here it is worth giving Russia as an example, wherein August-September the ruble fell by more than 15% after sanctions by the United States and Europe.
Also, geopolitics should add armed conflicts, various kinds of messages from top officials of countries, the creation of economic alliances, etc. An example is the unexpected results of a referendum in the UK (Brexit), which plunged the British pound by 11% to the September 1985 low.
Conclusion: it is necessary to follow the economic calendar and the main events on a global scale. But how they affect the course of a particular currency pair depends on many individual factors.