Currency prices are the result of supply and demand forces. Supply and demand for any given currency are influenced by several factors which fall into these three categories: economic factors, political conditions and market psychology.
Economic factors include government fiscal policy, monetary policy (reflected by interest rates), government budget deficits or surpluses, balance of trade levels and trends, inflation levels , economic growth, employment levels, retail sales. The more healthy and robust is a country's economy, the better its currency will perform, and the more demand for it there will be.
Political conditions: political upheaval and instability have a negative impact on a nation's economy and vice-versa.
Market psychology influences the foreign exchange market in many ways:
- When currencies are perceived as stronger over their weaker counterparts, there will be a greater demand and a higher price for them.
- "Buy the rumor, sell the fact" is a market truism that demonstrates how psychology can move the market: the price of a currency usually reflects the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in the opposite direction.
- There is a cognitive bias called anchoring: investors tend to focus too much on the relevance of outside events to currency prices.
- Some economic reports and numbers (trade balance figures, money supply, employment and inflation) take on a talisman-like effect: the number itself becomes important to market psychology and have an immediate impact on short-term market moves.
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