5 Important Factors for Economy

Key Factor 1. Interest Rates.

We use two methods to profit from the difference in countries' interest rates:

• interest income
• capital appreciation

Five Keys to Predicting Forex Market Movements

To profit from the fascinating world of international trade, you must have a firm grip on the key factors that affect a currency's value. When making our trades, we analyze five key factors. In order of importance, they are:

• Interest Rates
• Economic Growth
• Geo-Politics
• Trade and Capital Flows
• Merger and Acquisition Activity

Generating interest income.

Every currency in the world comes attached with an interest rate that is set by its country’s central bank. All things being equal, you should always buy currencies from countries with high-interest rates and finance these purchases with currency from countries with low-interest rates.

For example, as of the fall of 2006, interest rates in the United States stood at 5.25%, while rates in Japan were set at .25%. You could have taken advantage of this rate difference by borrowing a large sum of Japanese yen, exchanging it for US dollars, and using the US dollars to purchase bonds or CDs at the US 5.25% rate. In other words, you could have borrowed money at .25%, lent it out at 5.25%, and made a 5% return. Or you could save yourself all the hassle of becoming a money lender by simply trading the currency pair to affect the same transaction.

Generating income from capital appreciation.

As a country's interest rate rises, the value of the country's currency also tends to rise -- this phenomenon gives you a chance to profit from your currency's increased value, or capital appreciation.

Interest Rates Spark a 700 Point Rally

Another great example of the power of interest rates in the currency market occurred in August of 2006. At that time, the Bank of England surprised the market by raising its short-term rates from 4.5% to 4.75%. Interest rates for Japan were still at a low .25%.

The rise in England's interest rates widened the interest rate differential on the popular GBP/JPY cross from 425 basis points to 450 basis points. Investment money flowed into Great Britain as traders bought up pounds to take advantage of the new spread. As the demand for the GBP increased, the value of the GBP increased, and the spread between the currencies increased. This domino effect lead to a 700-point rally in the GBP/JPY over the next three weeks.

Key Factor 2. Economic Growth.

The next factor you need to consider when predicting a country's currency movements is its economic growth. The stronger the economy, the greater the possibility that the central bank will raise its interest rates to tame the growth of inflation. And the higher a country's interest rates, the bigger the likelihood that foreign investors will invest in a country's financial markets. More foreign investors means a greater demand for the country's currency. A greater demand results in an increase in a currency's value.

Hence, a ripple effect: economic growth inspires higher interest rates inspires more foreign investment inspires greater currency demand which inspires an increase in the currency's value.

Key Factor 3. Geo-Politics.

Do you hate the business section? Do your eyes glaze over at the mere mention of economic data and mind-numbing accounting numbers? Fear not. The currency market is the only market in the world that can be successfully traded on political news as well as economic releases. Because currencies represent countries rather than companies, they are political as well as economic assets and are therefore very responsive to any disturbance in the political landscape.

The key to understanding speculative behavior with respect to any geopolitical unrest is that speculators run first and ask questions later. In other words, whenever investors fear any threat to their capital, they will quickly retreat to the sidelines until they are certain that the political risk has disappeared. Therefore, the general rule of thumb in the currency market is that politics almost always trumps economics. The history of FX is littered with examples of political trades. Let’s take a look at some examples over the past few years.

Key Factor 4. Trade and Capital Flows

Before you make your final prediction about the trend of a country's currency, you should take a moment to categorize the country as dependent on either trade flow or capital flow. Trade flow refers to how much income a country earns through trade. Capital flow refers to how much investment a country attracts from abroad. Some countries are sensitive to trade flows, while others are far more dependent on capital flows.

Countries whose currency strength depends on their trade flows include:

• Canada
• Australia
• New Zealand
• Japan
• Germany

These countries achieve a large portion of their growth through the export of various commodities. In the case of Canada, oil is the primary source of revenue. For Australia, industrial and precious metals dominate trade, and in New Zealand, agricultural goods are a crucial source of income. Trade flows are also important for other export-dependent countries such as Japan and Germany.

For countries such as the US and UK, which have large liquid investment markets, capital flows are of far greater importance. In these countries, financial services are paramount. In fact, in the US, financial services represented 40% of the total profits of the S&P 500.

The United States also serves as a perfect example of why it is crucial to understand which flows affect which country in order to effectively analyze the direction of currencies. On the surface, the US currency, with its record multi-billion dollar trade deficit and near $1 trillion current account deficit should depreciate significantly. However, that has not been the case. As the chart below illustrates, the US has been able to attract more than enough surplus capital from the rest of the world to offset the negative effects of its massive trade deficits.

Key Factor 5. Mergers and Acquisitions

While merger and acquisition activity is the least important factor in determining the long-term direction of currencies, it can be the most powerful force in staging near-term currency moves. Merger and acquisition activity occurs when a company from one economic region wants to make a transnational transaction and buy a corporation from another country.

If, for example, a European company wants to buy a Canadian asset for $20 billion, it would have to go into the currency market and acquire the currency to affect this transaction. Typically, these deals are not price sensitive, but time sensitive because the acquirer may have a date by which the transaction is to be completed. Because of this underlying dynamic, merger and acquisition flow can exert a very strong temporary force on FX trading, sometimes skewing the natural course of currency flow for days or weeks.

If you keep abreast of international merger and acquisitions, you may be able to predict short-term fluctuations in FX. In late 2006, for example, Canadian economic data showed a great deal of weakness. Yet large demand for Canadian corporate assets from the Asia, Middle East, and Europe overrode the financial reports and kept the USD/CAD at all-time lows*.