These Are the Main Drivers of Exchange Rates in the Short, Medium and Long Run
Predicting exchange rates with a high success rate is far from an easy task. Besides being able to control your emotions and getting the right picture of the market, there are many other reasons why anticipating exchange rates is a tough endeavor. One of them is the sheer number of influences that affect the Forex market in the short, medium and long run, and many Forex traders simply don’t know how to correctly classify those factors in order to improve their trading performance. This article will give you a brief overview of the most important factors you need to consider when trading currencies in the short, medium and long-term, and why currency correlations also play an important role in trading.
Exchange Rate Determination in the Short-Term
Most traders start the process of learning online Forex trading with focusing on short-term currency moves. While this is not a wrong move per se, most of them still don’t pay enough attention to all the short-term influences in the Forex market.
The ultra-short-term Forex market (like many other financial markets) consists primary of market noise that is extremely difficult to predict. If we expand our definition of short-term to cover a period of a few days up to few weeks, then the following determinants play a major role in exchange rate movements:
- Crowd behavior – Market participants that feel that they have missed a strong up- or down-move will start to jump into the market. This kind of crowd behavior will add to the momentum and can accelerate the initial up- or down-move.
- Currency correlations – Currencies exhibit various degrees of correlations in the short-term. In other words, if a currency is poised to move higher in the short-term, another currency which is positively correlated usually follows the move, or goes in the inverse direction in case of a negative correlation. Think about GBP/USD and EUR/USD, where the former pair usually works as a leader of the latter one, i.e. they are positively correlated. By using a Forex currency correlation calculator, you can easily check the current correlation degrees in the market (negative correlation <0, positive correlation >0).
- Market sentiment – the way how the market feels about a specific currency can have a large impact on that currency’s price in the short run. Market sentiment is influenced by news to a large extent, so make sure to follow an economic calendar to stay up-to-date on major reports.
- Investor positioning – Another important factor to consider is investor positioning. While this is a contemporaneous indicator (when investors buy a currency, it should immediately reflect on its exchange rate), extreme bullish or bearish positioning can be considered as overbought/oversold levels, as we can expect that long and short positions can be either closed in the coming period, or that there is not enough buying and selling power to support the initial move.
Exchange Rate Determination in the Medium-Term
The medium-term in the Forex market can be considered a period of a few weeks up to six months. In the medium run, fundamental factors start to play in increasingly important role in the move of exchange rates, and traders need to pay attention to them when learning online Forex trading.
- Interest rate differentials – Interest rates are the price of money and international capital tends to chase high-yielding currencies in times of a risk-on market environment. This in turn increases the price of currencies with higher interest rates relative to currencies with lower interest rates. The expectation of rising or falling interest rate differentials play therefore a major role in medium-term exchange rate determination. Hint: interest rates show a clearer trend of rising or falling compared to currency trends.
- Monetary policy – The expected change in monetary policy is another important driver of medium-term currency moves. If the fundamentals of a country show that a tighter (or looser) monetary policy is more appropriate, the exchange rate will move accordingly. Follow central banks’ meetings and assess the outcome and key points of them to get a feeling for the future monetary policy of a central bank.
- Balance of payments – The balance of payments and the trend of its current and capital accounts can change the supply and demand for a currency. While current accounts are usually followed in this regard, note that with the fall of investment barriers between countries, capital account trends have started to have an increasingly important role in medium-term exchange rates.
Exchange Rate Determination in the Long-Term
Finally, exchange rate determination in the long-term includes factors that may move currencies in a period of up to a few years. While this may be beyond your trading horizon, learning online Forex trading cannot be complete without knowing whether a currency is over- or undervalued compared to its long-term equilibrium level. Long-term influences in the Forex market include:
- Purchasing power parity – The PPP model suggests that the differential in inflation rates can be used to determine the equilibrium of long-term exchange rates. In essence, this model is based that the purchasing power of two currencies needs to be in parity in the long run. However, evidence suggests that exchange rates can stay over- or undervalued for a long period of time before reverting to their PPP-equilibrium rate.
- Trends in Terms-of-Trade – The Terms-of-Trade of a country is heavily influenced by its main exporting/importing commodity. In other words, a rising oil price may be beneficial to the Terms-of-Trade of Canada, Russia, and other oil-exporting countries, and detrimental to oil-importing countries such as China. To assess the importance of a country’s Terms-of-Trade on the currency’s long-term exchange rate, you can follow the price-trend of its main exporting/importing commodity.
In order to anticipate future exchange rate movements with a relatively high success rate, Forex traders should combine all mentioned tools to assess exchange rates in the short, medium and long run.