What affects currency markets?

Currency pairs constantly change due to various factors. This is why foreign exchange markets are highly sought after by traders.

To gain a better understanding of the forex market, it’s important to know what can initiate a new trend in the right markets. Here are the most important factors related to volatility in forex – starting with the most significant, central banks.

1. Central Bank and Forex

2. Other Factors that Affect Markets
   
   

Central bank and Forex

As mentioned in the fundamental analysis course, central banks play a significant role in various financial markets. However, their influence on currencies is one of the most direct.

While the analysis focuses on technical aspects, it is important to know what central banks, which control the currencies you trade, are planning. To get started, here are the factors to watch for when trading USD, EUR, or JPY.

USD

The US dollar is by far the most traded currency. It appears in all major currency pairs, is the world’s reserve currency, and forms the foundation of financial markets.

This means that every popular forex pair is significantly influenced by the actions of the Federal Reserve System (Fed). The most important thing to monitor is the decision of the Federal Open Market Committee (FOMC), which meets eight times a year and sets the key interest rate for the US.

Markets focus on any signals regarding interest rates. If an interest rate hike is expected in the US, it can lead to a strengthening of the USD. Conversely, if a rate cut is anticipated, the dollar may weaken.

Keep an eye on CPI (Consumer Price Index) data and non-farm payrolls. Why? Because employment is a primary target for the Fed and future economic growth. High employment can lead to interest rate hikes, while low employment may result in rate cuts.

There is potential for USD movements to affect various pairs differently depending on whether the dollar is the base or quote currency.

EUR

The euro is the second most traded currency in the market, primarily because it forms half of the EUR/USD pair, which dominates global forex trading. The euro is also part of important currency pairs like EUR/GBP and EUR/CHF.

While the US is managed by the Federal Reserve System, the European Union has its own central bank, the European Central Bank (ECB). Key are the meetings of the ECB’s Governing Council, which occur every six weeks and make decisions regarding interest rates that national central banks (NCBs) use in cooperation with commercial banks.

JPY

Central banks do not only influence currencies through interest rates. Sometimes, a currency's value can be detrimental to the economy, leading to central bank intervention.

Japan's economy is heavily reliant on exports. Countries with high exports generally do not want their currency to appreciate too much, as it can harm the competitiveness of their exported goods.

If the JPY becomes too strong against the USD, Japanese exporters earn significantly less. They may need to raise their prices, potentially leading to a decline in overall sales. In this case, the Bank of Japan might intervene by flooding the market with JPY through cash releases. This surplus of supply would likely cause the yen to depreciate, resulting in an increase in the USD/JPY exchange rate.

Using intervention is particularly challenging because, unlike interest rate changes, these actions are typically only reported after they occur.

However, there can be signs that intervention is imminent, especially if the central bank repeatedly states that its currency is historically overvalued. Timing is difficult to predict and is usually a surprise.

Other factors to watch for

1. Government Announcements

Governments are responsible for fiscal policies that have a significant impact on currency values.
For example, if a government plans to finance a new infrastructure project, it will likely need to borrow money in the form of bonds that it sells to investors.

Fiscal stimuli are approved by governments, and sometimes a stimulus law must first be approved through a vote. It's important to stay informed about the latest developments so you don’t miss these critical decisions.

2. Market Sentiment

In its simplest form, fear can cause a declining market to turn into full panic, while greed can turn a rising market into reckless, wild buying.

An example of this was the eurozone crisis, particularly in Greece in 2010, which led to a massive sell-off of the euro as fear dominated investor thinking. Later, however, greed increased the currency's value, negatively impacting employment and inflation. The European Central Bank had to intervene to devalue the euro through various market mechanisms.

While it's easy to observe the effects of fear and greed after they have played out on the markets, it’s very difficult to predict when these factors will manifest in real time.

3. News

Not all news has the same impact on markets.

As a general rule, employment reports affect markets more than manufacturing data, and retail sales data has a greater impact than money supply reports.

An economic calendar is a great tool to help you determine which news events have the greatest influence. While not all significant news will immediately impact the markets, those with the most potential to do so are usually predictable, and monitoring them can provide a significant advantage for you as a trader.