Market participants should understand that all the current and available information is incorporated into the exchange rate of a forex pair. When new information becomes available, an exchange rate will immediately move to a new equilibrium rate that reflects the latest data. Further information is imperative whether you are trading the forex market using a technical analysis strategy or a strategy that reflects the macroeconomic environment. 

Some information is more critical than others, so it’s imperative to follow the essential data points that help drive the forex markets. Including monetary policy releases, the vital data include the U.S. Jobs report (NFP), the consumer price index (CPI), the manufacturing and services purchasing managers reports (PMI), Gross Domestic Product (GDP), and Consumers Confidence. These are the six economic and monetary policy indicators that drive the movements of the forex markets.

Monetary Policy is the Key to the Forex Markets

All economic indicators that drive market movements do so because they alter either trade flows or potential monetary policy. Monetary policy is a set of tools that a country’s central bank uses to promote employment and stabilize inflation. Most countries focus on inflation as a primary mandate and growth as a secondary concept. In the United States, the Federal Reserve, the central bank that controls monetary policy, focuses on two orders. The Fed has two jobs which are to control inflation and maximize employment. 

Central banks have several tools to control inflation and growth. The most well-known is controlling the borrowing rate. Most central banks decide the interest rates that banks lend to one another. In the United States, this rate is called the Fed Funds rate. While only banks use the Fed Funds rate to borrow and lend, this rate is used as the benchmark for longer-term borrowing. For example, the ten-year yield in the secondary market will change as the Fed Funds rate changes. The ten-year yield is driven by government borrowing. For example, the U.S. Treasury will issue ten-year bonds to borrow money to fund government spending. 

How are Interest Rates Used in the Forex Markets?

The bank borrowing rate is commonly used in the forex markets. The exchange rate used in the forex markets is called the spot rate and the forward rate. The spot rate is the agreed exchange rate that will occur within two business days. If the exchange date exceeds two business days, the rate is the forward rate. For example, if you decide you want to settle a forex transaction in 2-weeks, the rate used would be a forward rate. You would use a spot rate plus forward points to create a forward rate. The short-term borrowing rate is used to develop forward points, which make the forward rate. As the short-term borrowing rate changes, so make the forward points used to create the forward rate. There is a direct correlation between the borrowing rate used by banks to lend to one another and the forward rate used in the forex market. 

Since the forward rate changes with the borrowing rate, monetary policy becomes pivotal in determining the forward rates used in the forex market. Forex traders need to pay attention to one borrowing rate and concern themselves with multiple borrowing rates since each currency uses its sovereign borrowing rates to create the forward rate. For example, if you plan to trade the EUR/USD and settle a transaction in one month, you would need to use the borrowing rate of the Eurozone and the United States to create the forward rate for the EUR/USD. Additionally, the forward rate will help drive the movements of the spot rate. 

The interest rate differential, which is the difference between one borrowing rate and another, helps create the forward points. The higher rate will be more attractive to investors over an extended period. For example, if you are earning 4% with the U.S. interest rate and only 1% with the European interest rate, you will need to pay away (4-1) 3% if you buy the Euro and sell the U.S. dollar. 

If the forward rate makes owning the Euro more expensive than owning the U.S. dollar, traders will tend to purchase the dollar. 

Inflation is a Key Mandate

While monetary policy is one of the most critical factors driving the forex market, inflation is a key economic indicator you must follow. Since most central banks have a mandate of price stability, it’s essential as a forex trader to understand why a central bank would alter interest rates. Most central banks want prices to remain in a defined range. For example, the fed reserve has a target inflation rate of 2% in the United States. When inflation is above that level, the central bank will raise interest rates to reduce price increases. 

When inflation is below the target rate, the central bank will often lower interest rates to buoy growth and increase inflation. The metric that is often used to gauge inflation is the consumer price index (CPI). The Consumer Price Index (CPI) measures the average change in the prices consumers pay for a basket of goods and services. CPI is a broad-based measure of inflation used by many central banks worldwide to determine if interest rates need to rise or fall. 

Employment is Key in Some Countries

While inflation is crucial for most central banks, the employment picture can be equally important. In the United States, the dual mandate makes employment as necessary as inflation in creating monetary policy. The gauge used the most to determine the employment picture is the Non-farm payroll report. The U.S. Labor Department issues this report on the first Friday of every month. The report shows the number of new non-farm jobs reported monthly by a corporate survey. The information is accompanied by a household survey which reflects the unemployment rate. 

GDP Drives Trade Flows

While monetary policy is one of the most critical factors driving the forex market, Gross Domestic Product is a vital economic indicator you must follow. A GDP report shows the total growth in economic output. When the output is increasing, trade flows into a country rise. When trade flows rise, the currency demand increases, which helps a currency gain traction. 

Confidence Drives Currency Demand

When GDP and employment are rising, consumer confidence will begin to percolate. Consumer confidence is a survey produced by either a government or a private institution. Strong consumer confidence reflects increasing spending in a country and demand for a currency. Strong consumer confidence also reflects a robust stock market. To purchase stocks, investors need to own the currency of the country where the stock market is located. So, more substantial stocks usually lead to increased trade flows into a country and, therefore, higher demand for a currency.

Manufacturing and Services are the Most Timely

Survey data is generally the most timely. In many manufacturing and services countries, surveys are produced, covering industries. These surveys are called purchasing manager indexes (PMI) and give investors a gauge of expansion and contraction. The indices are based on a scale of 1-100, with 50 acting as the neutral level between the expansion/contraction level. Levels above 50 signify expansion, while levels below 50 reflect contraction. The PMIs also produce sub-indexes. The sub-indexes focus on different parts of the supply chain, including new orders and prices. The PMI surveys provide investors with a comprehensive view of the economic picture when it comes to a purchasing manager’s view of the economic landscape. 

The Bottom Line

The upshot is that many factors can impact the forex market. New information will change the value of an exchange rate as soon as it is available. The most critical pieces of information include monetary policy releases, the U.S. Jobs report (NFP), the consumer price index (CPI), the manufacturing and services purchasing managers reports (PMI), Gross Domestic Product (GDP), and Consumers Confidence.

While each piece of information is critical to the movements of the forex markets, changes in monetary policy will alter the forex markets immediately, especially if they are not expected. Generally, a central bank will telegraph what it plans to do, but on occasion, the information will not be conveyed to the market, and surprises will occur. 

Interest rates are a key part of the exchange rate. Recall that the forex market comprises a spot rate and a forward rate. The spot rate is delivery within two business days, and the forward rate is delivery beyond two business days. The forward rate is created by using the difference between two countries’ interest rates; therefore, any changes to monetary policy will alter the forward rate. 

While the actual change in monetary policy is critical, changes to inflation, employment, sentiment, and growth will also have an essential role in generating the value of a currency pair. Therefore traders will need to pay attention to some of the most timely data releases to keep abreast of what is happening that can impact the movements in the forex market.