The logic behind the rise and fall of the foreign exchange market: 9 core factors that determine exchange rate trends

To profit from forex trading, you first need to understand what drives currency price fluctuations. The international forex market changes daily, and these changes are not random; they are supported by clear economic factors. We have summarized 9 key factors that influence exchange rate movements, helping you quickly grasp market trends.

Short-term Impact: Interest Rates and Market Sentiment

The Power of Interest Rate Policies

Central bank interest rate decisions are among the most direct influences on exchange rates. When a central bank announces a rate hike, higher interest rates attract more investors to buy that country’s currency for interest income, directly increasing demand for the currency and causing the exchange rate to rise. Conversely, rate cuts lead to decreased demand and potential depreciation.

The Reserve Bank of India raising interest rates to counter the weakening of the rupee is a typical example—higher rates make the currency more attractive.

Irrational Market Sentiment

Besides fundamental factors, market participants’ expectations are equally important. When investors are generally optimistic about a currency, this positive sentiment reinforces itself—more buyers push prices higher, attracting more investors to follow suit. The environment of low mortgage rates in the US housing market during 2005-06 fostered expectations of rising home prices, which directly boosted the value of the dollar.

Medium-term Impact: The Battle of Economic Fundamentals

The Hidden Depreciation Effect of Inflation

Inflation is a key indicator of currency depreciation. When a country’s price level continues to rise, the goods purchased with the same amount of money decrease, reducing the country’s real purchasing power. This is currency devaluation. Investors naturally avoid currencies from high-inflation countries and shift to those with lower inflation rates.

Zimbabwe’s example is the most extreme—its staggering inflation rate led to a massive devaluation of the Zimbabwean dollar, ultimately making the currency completely unattractive to forex traders.

Employment Data Reflects Economic Vitality

Employment figures are important indicators of a country’s economic health. High unemployment suggests economic slowdown and reduced purchasing power, often leading to currency weakening. Conversely, strong employment data boosts investor confidence in the country’s economic prospects. The optimistic US non-farm payroll report, which caused the dollar index (DXY) to rise, is proof of this.

The Long-term Burden of Government Debt

Imagine investing in a heavily indebted company—investors would hesitate. The same applies to government debt. Countries with high debt levels have reduced ability to attract foreign investment, leading to weaker demand for their currencies and downward pressure on exchange rates. India’s poor rupee performance is partly due to government debt not decreasing despite rising oil prices.

Confidence Barometer of Capital Markets

Stock market performance directly reflects investor perceptions of the economy. If a country’s stock market continues to rise, it indicates capital inflows and investor confidence, often leading to currency appreciation. Long-term stock declines suggest bleak economic prospects and currency depreciation pressure. The surge in China’s capital markets since 2005 and its positive correlation with USD/CNH exchange rate movements exemplify this.

Long-term Impact: Structural Factors That Decide

Trade Terms Shape Long-term Competitiveness

A country’s export-to-import ratio determines its long-term currency appreciation potential. Countries with exports exceeding imports face upward pressure on their currencies because foreigners need to buy their goods with their own currency. China’s status as a major player in the forex market is partly due to its sustained trade surplus, providing a solid demand base for the yuan.

Political Stability and Policy Orientation

Countries with political stability are more likely to attract long-term capital investments. When governments can implement clear economic plans and take measures to improve living standards, economic growth potential increases, and their currencies have more room to appreciate. Brexit is a textbook example of how political uncertainty can severely damage a currency—on the day of the Brexit vote, GBP/USD experienced a sharp depreciation.

The Dual Role of Monetary and Fiscal Policies

Government monetary and fiscal policies reveal how friendly they are to investors. Policies aimed at attracting foreign capital will lead to continuous capital inflows, boosting demand for the currency. Conversely, restrictive policies cause capital outflows and currency depreciation.

Mastering these 9 factors will help you understand the logic behind forex market fluctuations. In the short term, rates and sentiment drive movements; in the medium term, economic fundamentals determine the outcome; and in the long term, a country’s trade competitiveness and policy stability are key. Next time you see exchange rate fluctuations, consider which factors are at play behind the scenes.