So, we’ve established that currencies can often have different values in practice, largely as a result of a combination of economic and political factors. But these notions of value aren’t usually fixed. For example, if £1 buys you $1.50 today, it might well only buy $1.40 tomorrow – the currency pairing here is in a constant state of flux. Again, there are any number of reasons why currencies fluctuate in comparison to others, and to cover all the individual bases for fluctuation is beyond the scope of this tutorial. Nevertheless, we can take a look at key reasons why currencies fluctuate, which will in turn give you a better understanding of how currency fluctuations might materialise in the near future when you come to trading the markets for real.
Reason 1: Intention
The first major reason why currencies fluctuate in value is because the relevant governments decide intentionally to stimulate the fluctuation. There are several key economic tools at their disposal for interfering with a currency’s natural value, and these can be deployed in situations where it would be advantageous to have a currency either devalued or gaining ground. Remember that a currency that is worth less makes exports more viable but imports more expensive, and the reverse is true for strong currencies. If a currency organically becomes too weak or too strong, a government might choose to invoke an increase in supply or stimulate currency demand to restore equity, or alternatively they may wish to stimulate or cool off domestic economic growth, for which currency fluctuation provides the perfect tool. Whenever you see quantitative easing (essentially printing more money), or an increase in interest rates, stop to consider the impact these will have on currency valuation and on the overall economic picture – for obvious reasons, it can be very worthwhile for governments to engage in intentional currency manipulation.
Reason 2: External Events
Another key reason why currencies fluctuate is in response to external events which prompt values to rise or fall. For example, if other competing currencies devalue, this can have the effect of pushing up the value of your base currency in a relative sense, and without taking deliberate stimulus action, there’s very little that can be done to offset this impact. Furthermore, increasing interest rates as a result of a recession, as a further example, might prompt currency values to rise which in turn will make it more difficult for exporters to do business. Remember that currencies play a key role in macroeconomics, and the health of national economies worldwide can be attributed to a greater or lesser extent to the management of its domestic currency in relation to other competing global currencies.
Reason 3: Markets
Thirdly, it’s commonplace for the markets to shift currency fluctuations through sheer supply and demand. If the market collectively, for whatever reason, decides to buy sterling, you can bet that sterling is going to rise in value. This is more than just a correlation – it’s a direct link, where market forces essentially determine the value of the currency and have the power to shift currency values in either direction. So, if a bank decides to sell off some of its USD reserves, you can rest assured that the value of the dollar will decrease incrementally as a result. In much the same way that share prices or any other market based assets fluctuate, so too can supply and demand contribute to the ultimately value of the currency concerned.
Having examined some of the main reasons why currencies fluctuate in value, you should now hopefully start to build up a more detailed picture of where investment opportunities arise. In spotting these opportunities within the forex market, you can apply the extensive degrees of leverage available to maximise your returns – the real trick lies in interpreting when these movements are going to take place, their direction, and how long any adjustments in value are likely to last.