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Understanding Currency Strength, Inflation, and Exchange Rates

Understanding Currency Strength, Inflation, and Exchange Rates

Currency Strength

Trading is all about identifying winning trends and acting in the most effective way. To reach that level of proficiency in both the identification and the execution of winning trades, there are few, but crucial factors traders need to understand.

Our article today explores three factors that, once understood, can open the door to multiple and replicable successes in the Forex market.

Concept of Currency Strength

The value of a currency reflects the strength of the economy of a country. The assessment of a certain currency’s strength is usually relative to a set of pre-defined currencies. For a better understanding of the concept of currency strength, we will breakdown and explain currency pairs.

A currency pair involves 2 currencies, the base and the quote currency.  Within the pair, one currency’s value is compared to the other to assess how many units of the quote currency one can get with a single unit of the base currency. As the value of the base currency increases, so does the exchange rate of the currency pair.

Let’s take the example of the CAD/USD currency pair:

How many US Dollars can be bought with a single Canadian Dollar?  The more US dollars can be bought with a single CAD, the higher the exchange rate for this pair.

Traders who long this pair want to see the value of the CAD increase. Shorts want to see the CAD drop in value.

The question then becomes: Why did the exchange rate on this pair increase?

  • Is it because the base currency (CAD) is stronger while the quote currency is remaining at the same levels?
  • Is the base currency (CAD) holding around the same level while the quote currency is weakening?
  • Is the base currency (CAD) strengthening while the quote currency is weakening?

Understanding the why behind a currency pair movement is important to manage risk and profits when trading Forex.

What are the key factors that can impact exchange rates?

Currency Strength

The balance of trade (difference between imports and exports for a given country) can strengthen or weaken a currency. It has a direct impact on the supply and demand dynamics for a currency.

The more a country exports versus how much it imports, the more demand there is for its currency. The opposite is valid as well: Less exports relative to imports result in a depreciation of the currency since there is less demand.

This is where Forex traders are at an advantage: They benefit from the ever-changing exchange rates fueling the retail Forex market and its extremely high liquidity.

The constant movement in commodities, imports, and exports translates into constant movement in currency prices which creates unlimited opportunities for everyone to profit in the Forex market. Online trading platforms and the tools they offer their clients make the process seamless as anyone can download mt4 Forex trading platform and start trading in the Forex market.

Inflation and Monetary Policies

Inflation is another factor than can impact a country’s exchange rates. Inflation happens when price levels keep increasing due to demand growing faster than supply, higher costs (wages, oil…etc.). Central banks, through monetary policies, try to manage inflation / interest rates which in turn impacts the exchange rates.

As a rule of thumb, a higher inflation rate usually weakens the domestic currency whereas a lower inflation does not necessarily mean that the currency’s exchange rate will appreciate.

Monetary policies adopted by a country’s central bank can significantly influence the strength of the currency’s exchange rates. In general, a country can either choose an expansionary, a tight, or a neutral monetary policy.

An expansionary monetary policy is when the money supply will be expanded by keeping the interest rates low to help the economic activity. Policies such as zero or negative interest rates encourage borrowing by individuals and companies whereas negative interest rates push banks to keep lending since they must pay central banks an interest on the money deposited.

Quantitative easing happens when the central bank attempts to increase lending by increasing the money supply through providing financial institutions access to capital. This in turn results in lower interest rates and exchange rates.

In general, domestic currencies tend to fall when the central bank opts for Expansionary monetary policies and reduced interest rates.

Tight monetary policies have the opposite effect on currencies. A government or a central bank can decide to increase interest rates to reduce the pace of economic growth which leads to an appreciation in the exchange rates.

To conclude, there is a direct correlation between the exchange rate of a country’s currency and the monetary policies adopted in the country. What this means for traders is there is a window of opportunities to identify profitable trends to make winning trades in the Forex market be it when a currency is trending up or down.

Today, traders can easily counter unfavorable impacts of currency strengths and inflation by joining the Forex Market. The key is to take action and choose the right tools to succeed.

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