As a trader, it’s important to stay on top of what moves the markets, and over the long term the main driver is good old “supply and demand”. If more people are buying, the price will go up. If more people are selling, the price will go down.
And what is it that drives supply and demand of currencies?
One major influence is the performance of the economy. The more products and services a country produces, the greater the demand for their currency. This is because international buyers need to stump up with local currency for their purchases.
A hot economy tends to increase inflation, which pushes up interest rates. Higher interest rates make a currency more attractive to buyers who wish to earn interest. Earning 5% interest is much more appealing than 0.1% interest! This is the genesis of the famous “carry trade”.
When a country has a booming stock market investors will flock to join the party, and when they do they need to buy shares with local currency. This adds to demand, as again, they need to swap their own currency for local currency before they can make the purchases. A strengthening stock market could also see a boost in merger and acquisition activities, providing another positive boost for the currency.
To oversimplify things, a high debt to GDP ratio weakens the economy – but when deleveraging (i.e. when you need to start reducing debt) begins to set in, a high debt to GDP could cause deflation. Deflation (when things get cheaper and the opposite of inflation) makes a currency stronger – not by creating demand but by reducing supply. If you have to stop borrowing and start paying off debt then there is a lot less money to go around – the same goes for countries and economies.
And let’s not forget the influence of central banks (and politicians) on currencies. The decision to print trillions of dollars of fiat currency is an obvious boost to the supply side of the equation, though it is a bit more complicated than that, as not all the new money finds its way into the economy.
Finally In 2013, we saw the massive growth of alternative currencies like Bitcoin – not linked to any government – and can’t help but wonder how will that change the supply and demand equation in 2014?
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