Why Do Forex Prices Fluctuate? Unveiling the 9 Key Factors Influencing Currency Appreciation and Depreciation

Trading in the foreign exchange market is not complicated, but the premise is that you understand what drives currency fluctuations. Is it political risk, economic data, or investor sentiment that determines a country’s currency value? The answer is: these nine factors work together.

We can categorize these factors influencing exchange rates by time cycle. Short-term fluctuations are mainly driven by interest rates and market sentiment; medium-term factors include political risk, inflation rate, government debt, employment conditions, and capital market performance; long-term trends are often reflected in trade conditions and fiscal policies.

Short-term Factors: Market Signals That React Quickly

How interest rate changes affect exchange rate trends

Central bank adjustments to interest rates are the most direct influence on exchange rates. When a country raises interest rates, its currency becomes more attractive—investors can earn higher interest income. The Reserve Bank of India once raised rates to prevent the rupee from falling, clearly demonstrating how rate hikes support the exchange rate.

Conversely, if you want to understand the meaning of the TWD depreciation, you should first observe Taiwan’s central bank interest rate policy. When the interest rate differential between the TWD and other high-yield currencies narrows, investors tend to sell TWD to buy currencies with higher yields, which is the core driver of TWD depreciation.

Market sentiment: the unseen but most powerful driver

Market sentiment is not an indicator that can be precisely measured, but it often best predicts short-term exchange rate fluctuations. When traders expect a currency to appreciate, herd behavior kicks in—mass buying pushes the currency higher, creating a self-fulfilling prophecy.

Between 2005 and 2006, due to low US housing market interest rates, traders were generally optimistic about rising home prices, and this optimism directly drove the US dollar’s appreciation. The same logic applies to Asian currencies—when regional economic prospects look good, currencies like TWD and SGD tend to appreciate; otherwise, they face depreciation pressure.

Medium-term Factors: The Contest of Economic Fundamentals

Political stability determines capital flows

No investor wants to put money into regions with high political risk. A politically stable country with a government actively improving living standards has greater economic growth potential, naturally attracting more foreign investment, which strengthens its currency.

In contrast, the Brexit event vividly illustrates the power of political risk—on the day of the Brexit referendum, the GBP/USD plummeted, as investors voted with their wallets, instantly re-pricing the GBP’s value.

Inflation rate differences create exchange rate disparities

Simply put, countries with lower inflation are more likely to have stronger currencies. If Country A has an inflation rate of 2% and Country B has 15%, investors will prefer to buy Country A’s currency. Zimbabwe’s history offers a profound lesson—when its inflation rate skyrocketed, the Zimbabwean dollar rapidly depreciated, eventually becoming one of the least favored currencies in forex trading.

Government debt: the current reflection of future burdens

A heavily indebted country is like a bankrupt credit borrower—no one wants to lend it money. High government debt makes it harder to attract foreign capital, ultimately leading to currency depreciation. Smart investors analyze government debt trends over the years to judge whether the currency is worth holding. One key reason for the weakening of the Indian rupee is that government debt has not improved despite rising oil prices.

Employment data reflects economic health

High unemployment indicates economic stagnation. When job opportunities are scarce and incomes decline, the entire economy loses vitality, and the currency will depreciate accordingly. The US Non-Farm Payrolls (NFP) report’s release often causes sharp fluctuations in the dollar index, illustrating how sensitive the market is to employment data.

Capital markets: a barometer of economic conditions

A long-term plunge in the stock market usually signals a lack of investor confidence, which can drag down the country’s currency. Conversely, an upward trend in capital markets suggests a positive economic outlook, leading to currency appreciation. For example, since 2005, as China’s capital markets soared, the USD/CNH (US dollar to offshore Chinese yuan) has experienced long-term upward pressure, reflecting investors’ expectations of yuan appreciation.

Long-term Factors: Forces Shaping Currency Destiny

The lasting impact of trade conditions

Countries with exports exceeding imports always see their currencies relatively strengthen. This is because foreign buyers need to use the country’s currency to purchase its goods, creating sustained demand. China’s role as a major trading partner in the forex market is precisely because its trade conditions have been consistently positive.

Currency and fiscal policy frameworks

A country’s currency combined with its fiscal policy framework can reveal the government’s attitude toward investors. If policies are designed to attract foreign capital inflows, investors will flock in, driving up the currency. This is the fundamental force that changes the long-term trend of exchange rates.

Practical Application: What Every Trader Must Know Before Trading

Understanding these nine factors is crucial for every forex trader. Short-term traders need to closely monitor interest rate policies and subtle shifts in market sentiment; medium-term investors should evaluate political risk, inflation, and employment data; long-term allocators need to delve into trade conditions and policy frameworks.

When you want to understand the meaning of TWD depreciation, start from this framework—examine Taiwan’s interest rate policy, political stability, inflation levels, employment market, and trade patterns, and you will find the real reasons behind TWD’s weakness.

Mastering these exchange rate determinants will enable you to predict the future performance of different currencies more rationally and make wiser trading decisions.