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Forex traders are tasked with the problem of having to process vast amounts of information on a daily basis. Every day, new world events and economic releases challenge the global picture and putting such events into perspective is perhaps a trader’s most difficult challenge.

However, it is often wise to ignore much of the news and instead focus on the fundamental factors that influence exchange rates the most.

Guest post by  FXTM

Interest rate differentials

On a short term basis, the differences in interest rates between countries, and more precisely, the outlook for interest rates between countries, is perhaps the biggest determinant of where markets move in the short term.

Interest rate moves are linked to inflation so that a country with higher inflation is likely to raise rates while a country with lower inflation is likely to drop rates.

On the whole, raising rates is bullish for a currency as it will encourage the carry trade. Also, by attempting to reduce inflation, higher rates make that country’s products more affordable to foreign buyers.

Lowering rates on the other hand leads to a depreciating currency.

Debt

Governments have always been keen to use their coffers to pay for public expenses, however, if that spending gets out of hand a large deficit can sometimes develop. To cover the deficit, governments usually propose a solution of money printing, something which generally leads to higher inflation over time. In addition, the government may reduce the price of some its financial assets in order to make them more appealing to foreign investors. This, along with higher inflation, reduces the demand for the currency and will see it drop in value.

And if there is any fear that the government will default then the currency will likely drop even further. One solution is to check the debt rating for a country from one of the big rating agencies such as Moody’s before investing.

Political stability

Currency traders, as well as stock market investors, also place a great deal of importance on political risk since a country with great prospects can be reduced to one of the poorest in the world at the hands of a corrupt or war mongering government. It is for this reason that research firms spend a lot of money calculating detailed risk reports on every country whose currency can be freely traded.

A country with a high level of political risk and economic instability will lead to a currency that is less in demand and that currency will depreciate. Political instability, for one thing, leads to a higher level of inflation as governments spend money to reach their sometimes dubious goals. Also, countries with high levels of political risk garner a much higher level of general uncertainty over their future prospects. Traders therefore prefer not to put their money at any unnecessary risk.

Further reading:  6 best currencies to trade