Currency Basics : What are the major fundamental factors that affect currency movements?
•Trade Balance - This refers to imports and exports, and is probably the most important determinant of a currency's value. When imports are greater than exports, you have a trade deficit. When exports are greater than imports, you have a surplus. A shift in the trade balance between two countries tends to weaken the currency of the country with greater deficit
•Wealth - Wealth is a country's reserves, in the form of gold, cash, natural resources, and so on. Basically any factor that affects a country's ability to repay loans, finance imports, and affect investments impacts the market's perception of its currency and the currency's value.
•Internal budget deficit or surplus - A country running a current account deficit has, on balance, a weaker currency than one that runs a budget surplus. This is tricky, however, in that the direction of the surplus or deficit affects perceptions and currency valuations too.
•Interest Rates - Funds move around the world electronically in response to changes in short-term interest rates. If three-month interest rates in Germany are running 1% less than three-month rates in the United States, then all other things being equal, "hot money" flows out of Euro into the Dollar.
•Inflation - Inflation in each country, and inflationary expectations, affect currency values. What good is a 10% short-term return in some country if inflation is running 15%?
•Political factors - Taxes, stability, whatever affects the international trade of a country, or the perception of "soundness" of the currency affect its valuation.
