The forex market is an investors heaven and hell at the same time. The same thing that make forex trading so exiting and profitable are the same that can break a trader faster than anywhere else. The one thing that sets the forex market apart from other financial markets is the significant volatility of the market. Currency is used everyday and everywhere, where people do businesses and there are so many players with conflicting interest that no one holds any true edge over others.
Central Banks around the world are of course the major institutions in the market trough their huge influence by setting interest rates. Central Banks don’t act on feelings or sentiments though, their objective is to stabilize the growth of their nations through monetary policy. So if you can actually predict a countries economic growth there is a good chance you can predict the interest rate changes from the central banks. Let us take a look at why economic growth is important to predicting interest rates.
To predict he movements of a nations currency we already know that it is useful to have some idea of the movements in interest rates. So how does the growth or lack thereof of an economy influence interest rates? Central banks have two somewhat opposed goals: To stimulate the economic growth of an economy by making sure there is credit available for investment and to balance inflation levels as to not undermine the currency. These two goals are rarely achieved simultaneously, which is why it makes all the difference to predict where the central banks are focusing their efforts at any given time. Let us look at the first scenario: Stimulating growth to cut in interest rates.
If the economy is under performing compared to what ever benchmark the central banks are using, then they may consider slashing interest rates in order to stimulate investment by making more credit available to borrowers. This means that more of the nations currency is being made available to the market which means that according to the laws of supply and demand results in a drop in price. Of course there may not be that big of an impact at any interest rate cut, specially if the market had already anticipated the move to some extent.
On the other hand, if a nations economy is growing and doing well there is always the inherent risk of inflation particularly from pressure on wages due to low unemployment. When this happens, traditional economic theory tells us that there is a risk the inflation can curb further growth. In this scenario the central banks will want to combat this by limiting the availability of money, they raise interest rates to encourage savings. This means two things: A reduction in currency from domestic savings and a reduction in available currency from international investors who crave that currency to take advantage of higher interest rates. The result is a rise in the price of that currency.
Understanding the basics of economic growth goes a long way towards understanding forex fundamental analysis.