Traders in the Forex market can begin by focusing on their local economy and currency, as these are the financial structures they know best. If a trader lives in the UK, the British pound and the health of the economy are daily topics in the financial news, so it is natural to view the foreign exchange market through the British pound.
Traders are also likely to hold their local currency, having earned it or come from financial activities in their country. But when it comes to exchanging or trading the currency they hold, traders need to broaden their scope and consider the global economy. In fact, currencies are traded in pairs and fluctuate according to each country’s economic performance and its place in the global economy.
Learning how each economy and each currency fits into the global context reveals the importance of the global economy in trade. Ignoring the factors at play on the other side of the currency pair can lead to errors in judgment and thus financial consequences.
Research in the global economy
The global economic ecosystem is a dynamic collection of major developed and emerging economies. Larger economies such as the US and the EU show steady but uninspiring growth, having reached a mature size with well-established and experienced organized infrastructures, central banks and fiscal policy governing bodies.
Some of the largest mature economies are members of the G7, which includes Canada, France, Germany, Italy, Japan, the United Kingdom and the United States. Together they account for around 54% of global productivity, an estimated £36 trillion (IMF figures for 2021).
Growing economies include the BRIC countries: Brazil, Russia, India and China. Together they represent around 30% of global productivity.
We can therefore consider that the global economy needs the stable supply and demand mechanism of mature markets, but relies on emerging, more volatile markets, such as China and Africa, to generate high growth.
What does this mean for Forex traders?
To break down a complex problem into more manageable parts, by studying the global economy you can find:
- which currencies are volatile,
- which currencies are strong or weak compared to a base currency,
- why currencies go up or down over a given period,
- and where to find potential trade opportunities.
What are volatile currencies?
In general, a reasonable level of price volatility is a normal and even desired market condition in forex trading. Returns are given on the price differences of currency instruments such as EURUSD or GBPUSD, which are considered the main currency pairs.
If an instrument moves sideways and the price does not change much, traders may lose interest in opening a position. When volatility turns into turbulence, only the most experienced traders can handle it, and most of them prefer to stay away from these high-risk situations.
The volatility can therefore be too high, too low or perfect, depending on one’s risk appetite.
Emerging currencies are more volatile than major currencies due to internal growth problems such as lack of prudent fiscal management, runaway inflation, excessive reliance on a single economic sector, excessive government spending and high debt. This is not to say that mature economies do not face their own imbalances, but rather that their existing infrastructure and experience help them adjust quickly through monetary policy and fiscal measures.
What are strong or weak currencies relative to a base currency?
To answer the question of which currencies are strong or weak against a base currency, let’s assume that the base is the British pound. A new currency like the Indonesian rupiah would be weaker against the GBP, so someone traveling from the UK to Indonesia would have more purchasing power than otherwise. The comparison between the British pound and the US dollar is a different story, as both these currencies belong to mature economies and are relatively stronger or weaker against each other depending on the economic development.
Why do currencies go up or down?
Currencies rise or fall due to the foreign exchange market’s response to stock market events and cycles in the global and national economy. Lower growth in the UK can often lead to a weaker currency compared to e.g. other mature currencies. When growth is strong, trader sentiment is optimistic and the currency is bought, showing an uptrend against other currencies.
Currencies also move based on central bank decisions, strengthening during hawkish periods and weakening during dovish movements.
Where to find potential trading opportunities?
Studying the health of the global economy can highlight potential currency trading opportunities, based on the growth patterns of emerging currencies against major currencies, relative weaknesses and strengths between major currencies, and currency trends triggered by central bank decisions.
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INFORMATION ON ANALYTICAL MATERIALS:
This content does not and should in no way be interpreted as containing investment advice or recommendations, an offer or a solicitation to trade in financial instruments. Please note that this marketing communication is not a reliable indicator of any current or future performance as circumstances may change over time. Before making any investment decision, you should seek the advice of independent financial advisors to ensure that you fully understand the risks involved.