Forex trading can offer traders many different benefits. However, to fully capitalize on existing opportunities, you first need to understand the factors that can affect currency prices.

Supply and Demand

The primary driving factor behind forex price movements is supply and demand. Taking the US dollar as an example, if the demand for the dollar increases—meaning more people want to exchange their currency for dollars—then the price of the dollar will rise unless the supply also increases accordingly. Similarly, if the money supply in an economy increases without a parallel growth in demand, the currency will depreciate. While five other factors are listed here, supply and demand is indeed the sole driving force behind forex price fluctuations.

Central Banks

Central banks have the greatest impact on the supply and demand levels of the currencies they regulate. This is mainly because they can control the benchmark interest rates of an economy. If you buy an asset using a high-interest-rate currency, you may receive higher returns. This can cause investors to flock to countries that have recently raised their interest rates, stimulating the economy and driving up the value of its currency. However, high interest rates can also make borrowing more difficult. If the cost of loans increases, investing becomes more challenging, which may lead to currency depreciation. Central banks can also change the level of money supply. For example, quantitative easing involves increasing the amount of currency in an economy, usually leading to depreciation. Understanding the impact of the Bank of England and the Federal Reserve on the market is essential.

Economic Data

Economic data is an indispensable factor in currency price changes for two reasons: it indicates the performance of an economy and provides insights into possible actions that central banks may take next. For example, if inflation in the Eurozone exceeds the 2% level that the European Central Bank (ECB) aims to maintain, the ECB’s primary policy tool to combat rising inflation is to increase interest rates in Europe—therefore, traders might start buying euros in anticipation of a rate hike. As more traders seek to buy euros, the EUR/USD currency pair may see a price increase.

One reason for the significant volatility in the forex market is the abundance of economic data available for analysis and evaluation. Check out our economic calendar for upcoming financial events, particularly noting the following: inflation data, GDP, production reports, retail data, and employment figures.

Credit Ratings

Investors strive to maximize returns from the market while minimizing risk. Therefore, in addition to interest rates and economic data, they may also consider credit ratings when deciding on an investment market. A country's credit rating is an independent assessment of its likelihood to repay debt; countries with higher credit ratings are considered safer investment markets compared to those with lower ratings. Credit ratings tend to be closely watched during upgrades and downgrades. Countries that receive upgrades in credit ratings may experience currency appreciation, and vice versa.

Investor Sentiment

Market movements are not always based on fundamental analysis; the overall sentiment of investors regarding the direction of asset price changes can also become a major influence on forex prices. For example, if most traders believe a particular currency will appreciate, others may follow suit. Some forex traders may completely ignore economic data when analyzing how to trade, instead looking for key trends and patterns to trade upon—this can mean that bear and bull markets can gain significant momentum without any supporting economic data.

Geopolitical Affairs

Global news reports can often have a significant impact on currencies, which ultimately will reflect on the forex market as traders assess their impact on supply and demand. For instance, when China announces a new construction project, if traders believe the US will provide materials for it, then the US dollar may appreciate.Conflicts may also lead to forex volatility. During times of increased geopolitical risk, investors often seek safer investment arenas, meaning currencies deemed risky may be affected, while “safe-haven” currencies like the Swiss Franc and Japanese Yen may rebound.