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Predicting the direction of forex markets is notoriously difficult, in fact there are many people in the academic world who believe it to be almost impossible – at least on a short term basis.

On longer time frames, there is more agreement, and many of those who study macroeconomics believe that the trick to predicting where a currency might go is to look at a country’s current account balance.

The current account balance is the sum of the balance of trade, factor income and cash transfers – where factor income means earnings on foreign investments minus payments to foreign investors. It basically describes the flow of money between two countries.

Guest post by  FXTM

Supply & demand

Macroeconomic theory dictates that a country’s currency is subject to the same laws of supply and demand as any other asset. If a currency is in greater demand it will be come to be worth more, whereas if it is greater in supply, it will depreciate.

To understand this, consider a country whose inhabitants develop a strong urge to buy products from a foreign country. In this situation, the act of buying foreign goods will increase the demand for the foreign currency since that is what the goods are priced in. At the same time, the current account balance of the country will deteriorate as more imports are coming in compared to exports.

The result is a trade deficit and a depreciation of the native currency since it is in much less demand.

However, there are other scenarios too.

Consider for example, a country whose financial products, such as bonds become wanted by foreign investors. In this case, the current account balance would also deteriorate (as a result of negative cash transfers), but the currency would go up in value instead of down. Since the increase in demand for the country’s financial assets means an increase in demand for its currency.

Longer term outlook

Economists tend to disagree on just how easily the current account balance can be used to predict foreign exchange prices. However, it is generally thought that current account deficits that go on for a long period will lead to a depreciation in a country’s currency. While prolonged current account surpluses will lead to appreciation

While it would be extremely difficult to use such data to trade forex markets in the short term the current account balance can provide some use for predicting markets over longer term horizons.

The data can be freely found online and it is also released monthly by governments. One idea would be to use the current account balance as one factor in the development of an indicator. Such an indicator could be used to decide which side of the market to trade on; long or short.