Currency Market

Economic conditions in a specific country will impact the overall supply and demand of the country’s currency. Unemployment data, inflation, retail sales, manufacturing data all provide insights into how the local economy is performing. Depending on how well the underlying economy is performing, the Central Bank will set monetary policy in an attempt to stimulate an underperforming economy or cool an overheating economy. The policies set by the Central Bank will indirectly impact the strength of the local currency. Generally speaking, during periods of rising interest rates (due to an overheated or strong economy), the local currency will strengthen against other currencies. As the interest on the cash positions has increased, the demand to hold the local currency from a domestic and foreign perspective increases. Foreign investors will want to have exposure to a currency with higher interest. During periods of decreasing interest rates (due to a weak economy), the local currency will decrease in strength against other currencies. 

When interest rates are decreased or even taken into the negative territory, the Central Bank is attempting to push investors out of holding cash positions due to the decreased rewards, investors are even punished for holding cash when interest rates are in the negative territory. Investors will consequently look for other alternative investments in an attempt to generate a return on investment or prevent the loss of money. As the financial markets are forward looking, currencies will begin to price in what the market consensus is. Therefore, a currency may begin to weaken prior to a Central Bank decreasing interest rates. Prior to a rate cut, the Central Bank will begin to use negative comments (Dovish) in its policy statements.  As a currency trader, we also need to be forward looking and use the economic data and central bank policy statements to guide our positions.

When interest rates are increased, investors may rotate out of higher risk investments and back into cash positions. Investors may have taken larger risks during times of low interest rates to stimulate a return on investment or prevent a loss. Those same investors may secure some profit and increase their cash positions when interest rates rise. It is not only interest rate hikes that you need to be aware of, you will also need to watch the central bank quantitative easing program. Generally speaking, when a central bank increases interest rates, they will also slow down or pause the amount of money they are printing. This is known as a tightening policy position. A decrease in the money supply can in-directly hurt other markets.