The global forex market or foreign exchange is one of the biggest entities of its type anywhere in the world, with this producing a daily trading volume in excess of $6.6 trillion.
Interestingly, the price of international currencies in the marketplace is governed by floating exchange rates, which fluctuate in real-time and are influenced by a number of macroeconomic and geopolitical factors.
In this post, we’ll explore these factors in further detail, while asking why they have such a pronounced impact on currency exchange rates:
#1. Interest Rates
Let’s start with the basics; as interest rates remain one of the most influential and impactful factors on real-time currency exchange rates.
In simple terms, an inflated currency base rate translates into a higher value, whereas reduced interest rates lead to considerably lower values.
This was borne out during the coronavirus pandemic, when nations across the globe sought to slash their base interest rates as part of wider quantitative easing measures.
So, as base interest rates were slashed globally, we saw currency values depreciate accordingly, while capital inflows from overseas also declined as foreign investment became far less appealing.
#2. Government Debt and GDP Values
Government debt refers to the public or national levies owned by a central government, with this metric often observed by reviewing a particular country’s debt-to-GDP ratio.
Unsurprisingly, we’ve seen debt-to-GDP ratios increase throughout the western world in the wake of the coronavirus, creating a scenario where afflicted international governments are less likely to acquire foreign capital.
This can lead to continued inflation, as foreign investors look to sell their government bonds in the open market within a relatively short period of time.
Over time, we’ll see a subsequent fall in the value of associated exchange rates, with this trend only likely to reverse as debt-to-GDP ratios improve and investment levels increase.
#3. Inflation
This brings us neatly onto inflation, which even by itself is a key factor when determining free-floating exchange rates in real-time.
Generally speaking, a nation with a lower rate of inflation will simultaneously see the value of its currency appreciate, while the corresponding price of its goods and services will also increase at a slower and more manageable rate.
As we’ve touched on, of course, rising national debts can lead to increased inflation, creating falling currency values and (typically) higher interest rates.
This also highlights the cyclical nature of the relationship between inflation and interest rates, which is why quantitative easing and monetary policy can have such a key bearing on currency values.
