What Are the Key Economic Indicators Influencing Exchange Rates?
Understanding what factors affect an exchange rate can sometimes seem like a mysterious magic act. Exchange rates are nothing more than the price of a currency: just as you look at the price of a litre of petrol in pounds sterling when you pull into the petrol station, to see if it has gone up or down, you can look at the price of a foreign currency (in the form of an exchange rate) to see if that price has risen or fallen in pounds sterling. The price of a litre of petrol rises and falls in response to supply and demand, which is affected by factors in the world, such as international trade, which uses petroleum to power ships, trains, and airplanes. Political events can also make it difficult to export or import oil from certain countries, along with general economic news that affects the amount of petroleum used. In the same way, exchange rates are affected by key economic indicators, such as changes in capital markets, international trade, political events, and economic news.
Capital Markets Indicate Changes In Currency Exchange Rates
The movements of capital markets in various countries are a broad indicator of potential changes in exchange rates. Changes in a country’s capital markets can influence the value of its currency, which is reflected in its exchange rate. A country’s debt and equity markets anticipate the changes to broader economic indicators within the country, as the value of the securities in the markets are based on the fortunes or failures of the companies in the country, which are in turn based on the health of their sales revenue.
Exchange Rates Follow International Trade Balances
Exchange rates often very closely follow the fortunes of a country’s international trade. A country’s international trade balances reflect the inflows and outflows of goods and services. When a country has a trade deficit, that country is a net importer of goods and services from other countries. Therefore, more of the local currency will be sold in order to pay for those goods and services, usually causing the currency’s exchange rate to trend lower. This is a reflection of basic supply and demand: more businesses and people in a country “give away” their currency in exchange for goods and services from foreign countries. As they give away their currency for foreign goods and services, this creates a surplus of their currency. This surplus acts on the exchange rate to push it lower. For example, early in the 21st century, the United States faced an enormous trade deficit (US$419 billion in 2002), and saw its currency drop by a weighted average of more than 9 percent versus a broad group of major trading partners between February 2002 and July 2003.1,2
On the other hand, a trade surplus causes the exchange rate to increase: as foreign buyers seek to purchase the products and services being offered by the businesses in the country, those foreign buyers seek to purchase that country’s currency, increasing its scarcity and its price.
Government Policies Influence Currency Exchange Rates
The policies a country’s government implements can have a significant effect on a currency’s exchange rate. As policies promote or suppress certain parts of a country’s economy, those changes can affect how desirable its currency is, in turn affecting the currency’s exchange rate. For example: a country implements policies which offer government subsidies, or lower tax rates, for an industry such as aircraft manufacturing. Foreign airlines purchase that country’s manufacturer’s aircraft, meaning those purchasers need that country’s currency. In Europe, for example, European governments paid for much of the research and development costs of the first Airbus aircraft and, even today, Airbus receives some subsidies.
Government policy also affects a currency’s exchange rate in other ways: elections, policy changes, and the balance of power of political parties can change the direction of a country’s economy. As the economy increases or decreases, so does the currency’s exchange rate. Central banks can also influence the currency’s exchange rate: as they adjust interest rates up and down, the exchange rate is also affected. A higher interest rate in a country can lead to the currency rising in value, as foreign investors seek to invest their money in the country’s debt, requiring that they purchase that country’s currency.
Economic Releases
Economic releases, such as releases of statistical information by a country’s government agencies, also have an effect on exchange rates. Some of the most widely referenced economic releases (also referred to as economic indicators) are a country’s Gross Domestic Product (GDP), inflation rates, unemployment data, manufacturing indices, retail and consumer goods sales figures, new home construction figures, and lending data. Ideally, positive data generally will lead to a more desirable currency, leading to a higher exchange rate. This is not always true, as sometimes contradicting data can cause concerns of an impending imbalance in a country’s economy, with changes to the exchange rate following soon thereafter.
The Takeaway:
The monitoring of basic economic indicators supports companies in forecasting and intelligently planning currency transactions to take advantage of favourable currency exchange rates.
Sources
- "U.S. Trade in Goods and Services - Balance of Payments (BOP) Basis", U.S. Census Bureau; https://www.census.gov/foreign-trade/statistics/historical/index.html
- "Trade Weighted U.S. Dollar Index: Broad (DTWEXB)", Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DTWEXB/downloaddata
