Long-Term Factors Driving the Foreign Exchange Market: Capital Flows

Before starting to follow a particular trading strategy, you should have a deeper understanding of the factors, which drive the Foreign Exchange market. There are plenty of views about what the most reliable strategies are – some traders rely on fundamental analysis, others rely solely on technical indicators. However, the best strategies probably involve both. There are cases when technical patterns turn out to be a failure, because of the release of some major economic reports or announcements by central bank officials. There are also cases when significant movement is present, because of some price action setup, while no economic indicators were released. Therefore, traders on technical analysis should be aware of the release of major economic data or other fundamental events, while fundamental traders need to be aware of key technical levels, which the general market may take into consideration.

Fundamental traders need to be constantly on top of events and news, that may have a serious impact on political, economic and social environment. We devote a whole chapter on the most important fundamental indicators in our Forex Trading guide. Now let us take a look at some major factors, which determine movement of currency pairs.

Capital and Trade Flows

Capital Flows

Capital and trade flows comprise the balance of payments of any country, an indicator in tight relation to demand for a given currency over a given period. A balance of payments amounting to zero usually means that the particular currency will maintain its present valuation. If a countrys balance of payments is positive, this indicates that capital is entering economy at a faster rate than it is leaving, therefore, the value of countrys currency should increase.

Capital flow, on the other hand, indicates the net amount of a given currency, being purchased or sold as a result of capital investments. If nations capital flow balance is positive, this means that foreign inflows of physical or portfolio investments in the country surpass outflows from the country. If nations capital flow balance is negative, this means that foreign investors hold less physical or portfolio investments than domestic investors.

Flows of physical investments include foreign direct investments, made by business entities in sectors such as manufacturing, real estate, or local corporate acquisitions. These investments require that foreign business entities purchase the local currency and sell the foreign currency, which triggers movement in the Foreign Exchange Market. These flows reflect the changes in actual investment activity. They change as a result of changes in the financial state and economic growth prospects of a given country. Changes in domestic laws in order to spur foreign investments also stimulate physical flows.

Flows of portfolio investments include capital inflows and outflows in stock and fixed income markets. A surge in the stock market in any region of the globe lures investors from any geographic location, because of the sharp advance in technologies, which facilitate transportation of capital. This has led to a significant correlation between the stock market in a given country and its own currency. In case the stock market is in an uptrend, investments in the local currency increase, as many individuals and companies are not willing to miss the opportunity to profit. In case the stock market is plummeting, local investors will begin selling-off shares of public companies and move their capital to more tempting opportunities abroad.

Fixed income markets also have a correlation to the Foreign Exchange market. Investments in assets with fixed income greatly increase in periods of global economic or political uncertainty, as these assets have an inherent safety. Countries presenting the most valuable fixed income opportunities will usually attract investments from abroad, which will require the purchase of the respective local currency.

Short-term and long-term yields of government bonds worldwide serve as gauges of capital flows in fixed income assets. Traders usually pay close attention to the spread differentials between the yield on 10-year government bonds of the United States and the yield on government bonds of other countries. It is so, because international investors usually put their capital in countries, which offer assets with the highest yields. In case Canadian assets, for example, offer one of the highest yields, this would lure more investments in Canadian financial instruments and would also increase the value of the Canadian dollar.

If an investor is to follow the flow of funds in a short term, an appropriate gauge are the spreads between two-year government bonds of given countries. Federal funds futures are also a useful gauge of the movement of United States funds, as they reflect expectations regarding Federal Reserve interest rate policy in the future. In the euro zone, futures on Euribor (Euro Interbank Offered Rate) reflect expectations over European Central Bank rate policy in the future.