How to Start with Mini Forex Trading

Three Major Movers of Currencies

Many know that a company’s earnings move a stock. So what moves a country’s currency? While there are many factors involved, let’s look at three of the most important things that move them.

1. Interest rates Each country’s currency has an interest rate attached to it which is set by that country’s central bank. So when you hold a certain currency, you’re able to earn that country’s interest rate on that money. Money is attracted, most importantly, to rising interest rates. So when rates are high and going higher, money moves out of lower yielding instruments and into higher yielding instruments. After all, would you rather earn less on your money or more? More of courseMany others feel this same way. So that’s what makes the currency go up. More investors are buying that country’s currency to get the higher yield associated with it. This influx of buying drives up the demand for the currency and forces it higher. So the next question is: How do I get into the mind of the central banker of that country to know if he’s likely to continue raising his country’s interest rates? If I can figure that out, then I know the currency is likely to go higher and I’ll actually earn more interest. We figure this out by watching the CPI numbers.

2. CPI (Consumer Price Index) – is the “cost of living” index. It measures a basket of goods to see if those costs are rising or falling. These will include things such as transportation, food and medical care, etc. The central bank watches these price levels. If they continue to rise, then they know inflation is becoming a problem. A country can’t continue to grow in a healthy manner if inflation gets too high. So how do they combat this? They do it by raising the interest rates. Raising rates increases the costs associated with borrowing and makes it more costly for businesses to expand and grow. This tends to cause businesses to slow a bit which “cools” the demand placed on consumer goods and causes them to back off to levels that the central bank is comfortable with. Conversely, cutting interest rates tends to give an economy a “shot in the arm” and helps to jump start it again. This is what the central bank in the U.S. is doing right now). However, money runs away from falling interest rates and pushes that country’s currency downward as investors sell the currency.

3. Risk Aversion The former two are associated with risk seeking. However, the alternative is risk aversion. This is when the market suddenly doesn’t want to take on risk to “seek higher yields”. This happens when markets get volatile and shaky. For instance, when stock markets have steep declines, money runs out of them and into something considered beaten down (oversold). This is what “risk aversion” is. Investors are trying to shield themselves from risk, so they run to things they think will either fall much less or hopefully not at all. So they’ll usually run to assets that have been largely sold over the last 1-3 years. Lately an example of this would be the Japanese yen. Even though their fundamentals are stable, their currency has continued to drop over the last few years as investors sold the low yielding yen to “seek” higher returns on their money through higher yields. However, when financial markets get shaky or overly volatile, money runs from these higher yielding instruments. As economies start to “cool” and slow down, an investor loses the incentive to be in that currency much like a stock investor does when a company’s earning growth loses its momentum.

So the questions to ask yourself are: Is the market in risk seeking (stable) mode or is it in risk aversion (volatile, shaky) mode? Also, watch the CPI levels to see if they are increasing or flattening out or falling. If they are rising and they continue to rise above a central bank’s comfort level, then look for rate hikes ahead. If consumer prices have flattened, then inflation may be under control and they may be able to hold rates steady. If consumer prices are falling, then the central bank may actually have to cut interest rates to encourage business expansion.

If the market is in risk aversion mode, then it’s scared. When money gets scared, it looks for safe havens. So then ask yourself, what’s been largely sold over the past 1-3 years and could be due for a bounce back. This is where they money may run to.