You will learn about the following concepts
- Basic fundamental concepts
- Currencies and what drives them
- Commodities and their link to currencies
- Crude oil
This article will delve further into fundamental analysis to uncover many of the specifics in trading some of the most popular binary options. We will speak about the main driving forces on the currency markets, as well as commodities, and the link between the two. So lets get this lesson started.
One of the most important forces that move currencies are interest rates differentials. In order to battle the negative effects of the 2008 global financial crisis, many central banks resorted to very, and in some cases record low interest rates. However, with the gradual improvement of the global economy, central bankers in some parts of the world began to tighten rates and the widening of interest rate differentials between some currencies brought the so-called “carry trade” back on the table. In this article we will cover only the basics of interest rate differentials and carry trades. To learn more about carry trades and a relative Forex trading strategy, read “Using Carry Trades to Maximize Profit“.
The value of a currency, given that it has a floating exchange rate (it is not pegged to any other currency), is determined by the demand for it. Generally speaking, a currencys attractiveness grows depending on a number of factors. For example, if the country has a developed manufacturing sector, it will attract many foreign investors who want to open new factories there, or acquire existing ones. In order to invest capital, they will need to exchange their local currency for the currency of the nation they are investing in.
Another example is a developed tourism sector. The more attractive a countrys resorts are, the more foreigners will come to spend their vacation there. In order to conduct their everyday payments (buy food, pay for museums, pay for transportation), they will need to purchase a certain amount of the local currency in exchange for some other.
Both of the cases above presented an example where demand for the local currency rises as the respective individuals or entities need it to conduct payments on a local level. The biggest mover on the currency market, however, are interest rates. The higher the interest rate, the higher the demand for that currency will be as foreign investors are drawn to invest their capital there in order to yield a higher return.
And given that on the Forex market currencies are traded in pairs, their respective interest rate differentials will play a major role in the crosss movement. Let us assume we are trading USD/CAD. If the Federal Reserve decides to hike borrowing costs, or if traders are only speculating that an increase is likely, this will lead to the strengthening of the US dollar. As a result, its counterpart (the Canadian dollar) will weaken, provided that traders do not anticipate any change in Bank of Canadas monetary stance and there is no supportive economic data.
Thus, with some of the currencies already experiencing interest rate hikes, the carry trade is back in business. In carry trades, a trader sells a low-yielding currency (or borrowing money to do so) and buys a high interest rate currency. Thus, demand for high-yielding currencies is typically high, which further raises its value.
However, keep in mind that a very strong national currency is bound to begin dragging on growth. An expensive currency will leave the country with a disadvantage on the international trade scene, and as export growth begins to stall (or exports even decline), this will have a direct impact on the economys performance.
Central banks possess the power
When the national currencys value leaves the boundaries generally targeted by the central bank, so that economic growth and price stability are no longer ensured, the central back has the influence and means to intervene and bring it back in the desired range. Each trader, including binary options traders, should be on the lookout for central bank interest rate decisions, as well as speeches by central bankers.
Due to the central banks impact, in most cases they dont even need to take any measures, rather just speak out how the currency is undervalued or overvalued and that they dont like that. As a result, the general public almost always reacts in the way the bank desires. Very often you will see central bankers step out in front of media and hint that possible action might be taken, but usually they resort to these measures only, if the verbal interventions fail.
Commodities and their link to currencies
Demand for commodities has strong positive correlation to economic growth. During times of recession, commodities are generally trading at lower levels as economic activity, particularly industrial production, stalls. However, this principle does not apply in full force for all commodities, and we will mention some of the specifics in the next paragraphs.
Crude oil prices are driven by the supply-demand balance and any accompanying speculations regarding a possible imbalance. Logically, demand will be high when the global economy is in an upturn, and lower when economic activity declines.
On the supply side, prices will tend to drop when supplies are ample and there are no fears of disruptions. Conversely, when an infrastructure accident curbs output, or geopolitical tension threatens to decrease production and exports from a country (especially a major producer), this is seen as bullish for oil.
Crude oil prices are also influenced by the strength of the US dollar. Because oil is priced in dollars, the two tend to have an inverse relation. Strengthening of the greenback makes not just oil, but all dollar-denominated commodities, more expensive for foreign currency holders and limits their appeal as an alternative investment. In addition, when oil prices are high, this widens the US trade deficit (since the US is a major oil importer, while exports are capped at a fraction of total consumption), which lowers GDP.
Moreover, prices of certain commodities seem to be strongly correlated to the currencies of major producing nations. A prime example for that link is presented by the Canadian dollar. Canada is a major exporter of crude oil, and one of the few highly-developed economies with a net export of energy. Thus, the higher oil prices are, the more Canadian dollars foreign buyers will need in order to purchase oil. This in terms will drive demand for the currency up and add to its value. To read more on the subject, read our article “Profile of the Canadian Dollar – Economic Overview and Monetary Policy“.
Thus, an alternative way to trade oil is to bet on USD/CAD, but in an inverse manner. When you think of it, its quite logical. When oil is on the rise, the Canadian dollar will most likely follow (given there is no downbeat economic data to pressure it). If the US dollar does not draw support from any other factor, it will likely decline. However, if you are trading CAD/USD, then the pair and oil should move in the same direction.