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How Economic Strength Influences Currency Fluctuations
Perspective | 23 January 2013
By: Stuart McPhee
Articles (22) Profile

Deck: Currencies trade in pairs. The strongest trending behaviors tend to follow a pair of weak versus strong economies.

In a previous article, we briefly discussed the influences supply and demand can have on one particular currency. In this article, we will take a closer look at factors influencing a few prominent currencies.

Determining Economic Strength
In order to do business in Singapore, one must transact using Singapore dollars (SGD). When Singapore’s economy grows, the number of transactions increases as does the demand for more SGD, in-turn driving up the SGD’s strength. This is an overly simplified example but it aptly illustrates how economic growth results in a stronger SGD. The USD/SGD pairing exemplifies this relationship: a strong Singapore economy versus a weak U.S. economy drives the USD/SGD exchange rate from $1.55 to today’s $1.23.

Some measurements of economic strength would be Gross Domestic Product (GDP) and Gross National Product (GNP) data. However, these numbers are backward looking. Forward-looking figures include manufacturing and labor data and consumer confidence/spending. This data will give us an understanding of how the economy will look in the months and years ahead.

Also, as currencies trade in pairs, the strongest trending behaviors tend to follow a pair of weak versus strong economies (e.g. EUR/AUD, AUD/USD from 2008 to 2012).

Interest Rate Differential
Interest rate parity states that the interest rate differential between two countries will be reflected in the forward exchange rate with no arbitrage opportunities holding either currency. The formula is as follows:

ihome = Interest of Home Currency earned after 1 Period
iforeign = Interest of Foreign Currency earned after 1 period
Exchange Rate = Foreign Currency/Home Currency
Forward Exchange Rate = Exchange Rate after 1 Period agreed on Today

In an AUD/SGD example:

Home currency = SGD
Foreign currency = AUD
1Yr Home Interest Rate = 1%
1 Yr Foreign Interest Rate = 3%
Current Exchange Rate = $1.50

Based on the following details, we can work out today’s 1Yr Forward Rate:

Therefore, 1 Yr Forward Rate = (1.01)/(1.03) x 1.50
= 1.47

Another way to look at it is this:

Should any component of this equilibrium be different while the rest remains the same, traders would be able to take advantage of this relationship to profit without any risk.

It is important to note that even though the 1Yr Forward Exchange Rate today is $1.47, it does not mean that AUD/SGD will fall back to 1.47 one year from now. From this example it seems to suggest that a higher interest rate leads to a lower future exchange rate. Does that mean that a cut in the Reserve Bank of Australia’s interest rate will bring the AUD/SGD forward rate higher? On the contrary, it does not.

In our next article, we will examine how changes in Central Bank interest rates influence currencies.

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Stuart has more than 16 years of trading experience under his belt and specialises in technical market analysis of major currency pairs. Apart from being the author of several bestselling trading books, with his most recently released book "Trading in a Nutshell", Stuart contributes to daily newletters and blogs. He also produces articles and videos on the how tos of technical tradings. For more information of Stuart, you can follow him on twitter @stuartmcphee or check him out on Google+.

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