The very essence of the forex market is the flotation of currencies, which allows the value of each individual currency to be impacted by the forces of demand and supply. Supply and demand is created by all the market participants, in response to various market-driven stimuli. The combination of all these factors is what ultimately impacts the forex market.
So one hand, we have the forex market participants, and on the other hand, we have the fundamental socio-economic and political influences that sway the market sentiment of the market participants.
Market players do not just make decisions for the heck of it. They make decisions based on the bias that they have assumed towards or against particular currencies. This market bias is driven mostly by socio-economic and political factors, many of which are released to the market following an ordered schedule of release called the forex news calendar.
A typical forex news calendar shows a table of news events that detail economic data and political events affecting roughly 42 countries and their currencies around the globe. News releases are of low impact, medium impact and high impact. High impact news carry the greatest affectation for the currencies in view.
How do these news releases impact the forex market?
The major participants in the trading section of the market (institutional traders) are carriers of smart money. Smart money always seeks out where it can get the best returns. Therefore, any news which signifies a shift in the dynamics of a currency or an economy will ultimately decide whether the smart money will flow into that economy, or whether the smart money flows away from it. For smart money to be able to invest in an economy, it must purchase the currency of that economy. Therefore, if a piece of economic data emanates from the US and it turns out positive for the US economy, this signifies an opportunity for smart money to profit from the US economy. The smart money will therefore gravitate to the US Dollar to purchase it, so that it can gain entrance into the US economy and tap into the potentials for profiting from there.
Let’s look at an example. In late 2016, the US Federal Reserve decided to raise interest rates for the first time in several years. An increase in interest rate increases the cost of money in an economy. It also increases the returns on investment for borrowed funds. Treasury bills are a form of government borrowing, and an increase in interest rate signifies an increase in the interest the government pays the smart money investors for borrowing their money. To be able to purchase US Treasuries, the smart money investors have to exchange whatever foreign currency they have to acquire the US dollar. This increase in demand for US Dollars triggers a rise in the value of the US Dollar against other currencies. This explains why the Fed’s interest rate hike in December 2016 was followed by US Dollar gains across board.
Every high impact news item found on the forex news calendar as well as political events found outside of the news calendar, pushes the smart money investors to answer one question: will this news item enable us make money in this economy or not? This pushes the investors to take a position either for a currency or against a currency. This is how the fundamentals impact the forex market.
The forex market participants are arranged at various levels. They are as follows:
- Central banks
- Forex brokers (market makers and direct market access brokers)
- Institutional traders (hedge funds, high net-worth individuals, global banks, commercial banks).
- Retail traders
Each of these market participants are arranged in some sort of a pyramid, with the banks on top and the retail traders at the bottom. The central banks have the capacity to wield the most influence. This is not only because they influence monetary policy and interest rates, but also because they have the capacity to influence the forex market on a scale other participants do not have using market interventions. During market interventions, central banks have the capacity to massively increase the supply of a currency from their foreign reserves. For instance, the following central bank interventions have occurred in the last few years in the global forex markets:
- The Bank of Japan has performed a series of interventions to weaken the Yen. In August 2011, the BoJ purchased assets by selling 10 trillion Yen, as part of the country’s effort to boost the export-competitiveness of the Japanese economy.
- Swiss National Bank: Was able to maintain the peg between the Euro and Swiss Franc at 1.2000CHF to 1 Euro for three and a half years by buying up foreign currencies with amounts that as at 2014, was equivalent to 70% of the country’s GDP.
- Central Bank of Nigeria: sold $7billion over a period of 6 months to strengthen the local currency (the Naira) from N505/$1 to N360 to $1.
- The Central Bank of Russia spent close to $700million to prop up the Ruble in December 2014. It is also believed that close to $30billion was spent in 2014 to prop up the currency during the worst of the currency’s crisis that occurred as a result of Western-backed sanctions on Russia’s financial system.
Central banks intervene in the forex market for various reasons. For some countries such as Japan and Switzerland, it is about making their exports cheaper and maintaining international competitiveness. For some countries, especially import-oriented economies, it is about providing stability in local prices of goods and services. Then there are those countries whose governments want to score political points, and undertake currency interventions to improve ratings among certain segments of their societies and make themselves re-electable. Whatever the case, central bank interventions are of such magnitudes that they impact the forex market.
Central bank interventions are not only in terms of control of monetary supply; they can also be in terms of their monetary policy. Adjustment of interest rates is one of the most impactful events in the forex market. This has been discussed earlier under market impact news.
Institutional traders typically trade in very large volumes. These volumes are large enough to affect the flow of orders in the forex market. For instance, the spikes seen in news trades are as a result of the orders placed by institutional traders. These news trades are done in response to the fundamental news releases in the manner that was discussed in the previous paragraphs.
The retail traders do not have much impact on the movement of currencies because their trade volumes are small. Most of the forex market impact is seen to come from the central banks, institutional players as well as the high impact news items that are released on the forex news calendar.