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Lesson 10: The Key Drivers Of Forex Markets

Module 1: Macro Fundamental Analysis

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Video Transcript

So in this video we’re going to look at foreign exchange markets and how they are affected by supply and demand now in the graph here we have very similar to what we’ve looked at in previous videos on the left hand side we have the price of pounds in u.s dollars so the price of one pound in u.s dollars so one pound is equivalent to 50 cents one dollar 1.50 two dollars two loads 50 etcetera and down the bottom here we have the quantity demanded so the quantity in this case quantity demanded of pounds so the graph itself is slightly different to what we’ve looked at before we’re used to so far looking at price level so the average level of goods and services within an economy and down the bottom real gdp and the difference between the two is we are not looking at an economy here we are not looking at total or aggregate numbers we are looking at the singular we’re looking at pounds so this is supply and demand of pounds it’s an individual product you could think of it as this could just as well be chocolate bars you could have the price of chocolate bars and the quantity demanded of chocolate bars and the only difference really between this and previous graphs we’ve looked at is this is a micro economic chart whereas previously we’ve been looking at macro economic models so in foreign exchange markets it’s very important to understand and remember that you can only convert into and out of one currency by converting into and out of another currency so you can only buy one currency by selling another currency you can only sell one currency by buying another currency so if we start off by looking at the top model here you can see if we look at the demand curve we have a simple demand curve labeled d1 and supply curve labeled s1 and very similar to what we looked at in previous models if you look and you start from the top left hand corner you can see as price comes down so as the pound weakens against the dollar as the exchange rate declines demand increases so the quantity demanded of pounds increases as the value of the pound declines so shifts along the demand curve price related shifts of the demand curve non-price related factors which we’ll be discussing later and the reason for this is very simple as the value of the pound comes down people who are not holding pounds see the pound as being cheap and they will be more prepared at lower prices to convert into pounds because they feel like they are getting a bargain

perhaps as the value of the pound decreases or declines people in america decide to go to the uk for a holiday so they convert into pounds why because it will be a cheap holiday for them so demand for the pound increases as its value falls and vice versa as the value of the pound increases perhaps that holiday starts to look a bit more expensive and so demand for the pound actually falls as well the quantity demanded of pounds declines at higher and higher valuations so a very simple way to think about supply and demand curves in the foreign exchange market is to first of all take the underlying country which the currency reflects so in this case we are looking at supply and demand curves for the pound and when you are thinking about the demand for the pound you are thinking about people who live outside of the uk people who do not have pounds looking to convert into pounds so you are looking at demand here for uk goods services and assets when you are looking at the supply of pounds you are looking at people who are in the uk themselves people who own pounds and people who are looking to convert out of pounds and this supply chart here is essentially demand from uk residents for foreign goods services and assets so converting into pounds rest of the world ex the uk their demand for uk good services and assets supply of pounds converting out of pounds uk residents and their demand for foreign goods services and assets so just like when we talked about that holiday as the price say we shift along so we’re not shifting the actual curve we’re moving along the demand curve as price comes down the value of the pound decreases what happens this becomes more attractive to the american tourist let’s say in this case because we’re looking at pounds dollars and therefore demand for uk services assets and goods increases so they are more likely to take that holiday and vice versa so now let’s consider factors outside of the exchange rate or price itself factors which we will go into more detail over here and throughout the course what happens if some of these key factors which affect the exchange rate take place and for whatever reason we have a shift to the right we have an increase in demand for the pound the demand curve shifts to the right well you can see what will happen in this case is our original equilibrium point here which is roughly at about 1.25 and our quantity demanded which is about 900 we can see that this shifts to the right as well and we have a not only a higher quantity demanded of pounds as the demand curve shifts right we also have a higher exchange rate you can see the new equilibrium price here is about 1.5 now this is very important because what this shows is if you can assess the factors which affect exchange rates which we’ll be doing as we go through the course and you can take positions as they happen or before they happen you can profit from the foreign exchange markets by subsequent in this case rises in the exchange rate because of an increased demand so as demand for a currency goes up it will rise in value of course if this were to happen the other way and for whatever reason because of factors which affect exchange rates there was a reduction in demand so the demand curve shifted to the left so the demand for pounds from the rest of the world went down then you can see that the exchange rate would also drop in this scenario so not only would the quantity of pounds go down so the quantity demanded of pounds from the rest of the world go down the exchange rate would also drop relative to let’s say the us dollar remember when you’re looking at currencies everything is relative so when we say the value of the pound going up we’re talking about relative to dollars in this case so the same really applies on the other side here the conversions out of the pound so the supply of the pounds so people who live in the uk domestic uk residents who own pounds who are looking to convert out of pounds to reflect their demand in foreign goods services and assets now yes i know of course technically speaking you could have somebody who lives outside of the uk converting out pounds or changing pounds into another currency but if you think about it in these terms this is really going to help you remember this as we go through the course and to wrap your head around the concepts of supply and demanding currencies because when we look at the factors which shift these curves these will be the reasons for buying and selling taking long and short biases and positions in the foreign exchange markets so as you can see we start off with an upward sloping supply curve just as we did in previous macro economic models and this is for the same reason as we looked at demand very simply as the value of the pound increases against the dollar there is more supply of pounds so british people let’s say are more prepared to convert out of pounds because they can convert out at a higher price and as the value of the pound declines let’s say against the dollar once again uk residents owners of pounds are less prepared to convert outer pounds because they are not getting quote-unquote as good a deal at this price as they are at this price so how would that look in the real world well let’s say for example you have a british tourist this time and they are looking to book a holiday in america and at this point over here they can get two dollars for every pound they are much more motivated to take that holiday and convert out of pounds into dollars because they can get a better exchange rate conversely sloping downwards so price related up and down the curve as the value of the pound declines against the dollar that american holiday becomes less and less attractive because maybe a year ago i could get 1.50 for my pounds now i can really only get say 50 cents or 75. so what i’ll do i’ll wait let’s say for a couple of years and as the pound rises in value against the lower that american holiday becomes more and more attractive so demand for foreign goods services and assets increases as the value of the pound increases and uk demand for foreign goods services and assets decreases as the value of the pound decreases that’s why this is an upward sloping curve here so what would happen then if we had a factor which is non-price related shifting the supply curve in the pound so you can see here we would have a shift let’s say to the right so supply increases there’s an increase in supply of the pound we would go from our first equilibrium area here of about 1.25 down to about one so you can see the exchange rate actually decreases so the pound loses its value against the dollar if there is an increase in supply so again an increase in supply in pounds is an increase in demand for u.s goods services and assets from uk residents from people holding pounds in this case so a brand new car is made in america everybody loves it it’s the future it’s got fantastic technology demand from the uk goes through the roof there becomes an increased willingness to sell pounds to convert out of pounds to get that new car and of course conversely a shift to the left so a decrease in the supply so a decrease in the willingness to convert out of pounds a decrease in demand for u.s goods services and assets from pound holders so uk residents and a decrease in demand from uk residents holders of pounds for u.s goods servicing assets would of course see a shift to the left and an increase in the value of the pound as less people are now willing to convert out of pounds and in two dollars so now we understand what the supply and demand curves in currency and foreign exchange markets represent and how shiftings of those curves can cause the exchange rate to appreciate and also to depreciate let’s now have a look at some of those factors which cause shifts in the demand and supply curves of currencies and as a result cause moves in the foreign exchange markets so the first thing to note is we are just looking at an overview here of these factors as we go through the course we are going to be looking in a lot more detail at inflation interest rates trade and more and how they can affect moves in the currency markets in stocks and how we can also preempt those moves but for the time being we’re just going to have a look at an overview of some of these key factors which shift foreign exchange markets so let’s start off by looking at inflation so why is inflation important well inflation is important because we defined inflation in previous videos it is the general level of prices or the average level of prices of goods and services within an economy so if you have for example let’s take an example of an american consumer so if an american consumer is looking to buy a good a service or an asset and they can purchase that good service or asset either domestically in the u.s market or they can purchase it internationally in the uk market they are faced with a choice and faced with this choice if there is a lower rate of inflation in the uk so by definition a lower rate of the average level of prices of goods and services within an economy this will create higher demand for the uk good service or asset because that u.s consumer can purchase the same good service or asset or something very very similar in the uk market at a lower price than if they were to purchase that good service or asset in the us market domestically so a lower rate of inflation in the uk relative to the us creates higher demand for uk exports to u.s consumers this shifts the demand curve in the pound to the right and conversely if you’re actually looking over here at instead of supply curves for the pound let’s say for a minute this is actually a chart for us dollars as demand for the pound against the dollar shifts you would see a shift to the right in the supply curve for dollars because if demand for pounds shifts to the right in relation to us dollars then supply of dollars must also increase because if demand increases from u.s consumers those u.s consumers must be prepared to sell their dollars so supply increases in dollars in order to convert into pounds to make that purchase in the uk market now the same would be true if we had a japanese consumer and perhaps the good the service or the asset could only be bought in the uk market or the u.s market perhaps it could not be bought in the domestic market of japan then a shift to the right an increase in demand for pounds could still take place if the relative rate of inflation in the uk was less than that of the us because the japanese consumer would still look to transact in the market with the lower average price of goods and services however if that were the case and there was to be a shift to the right in pounds it would be showing up in an exchange rate between pounds and yen so instead of pounds and dollars here we would see a shift to the right and we would see an increase in the pound versus the japanese yen so the relative rate of inflation is important a side note you may be saying to yourself but hang on you said that shifts of the supply curve or the demand curve in this case were non-price related how is it that inflation which is the general level of prices of goods and services a non-price related effect so to clarify what we mean by non-price related is the price on the y-axis so in this case the price of pounds in dollars so the exchange rate so the changing of demand or supply not due to fluctuations in the exchange rate so that’s not to be confused with just prices in general so what about interest rates well higher relative interest rates will create higher demand and the difference the arbitrage between interest rates is known as carry so if you purchase a currency with a higher relative interest rate while at the same time selling a currency with a lower relative rate of interest that is called positive carry and vice versa if you purchase a currency with a lower relative interest rate and you sell a currency in order to purchase that currency which has a higher relative interest rate this is known as a negative carry so let’s take an example this time of a domestic consumer inside the uk and they have their money in the bank and let’s say for argument’s sake they have quite a lot of money so the interest generated on that is quite significant they may actually decide that if they can get a higher rate of interest in the us by perhaps even purchasing u.s assets could be financial assets in order to generate a higher relative rate of interest or simply if they transferred their money into if they were able to into a bank in the us let’s say they actually split their time between the two then the uk consumer may actually take all of that money all of those pounds and convert out of pounds increasing the supply of pounds and in turn converting in to us dollars and at the same time if up here this were to be a us dollar chart rather than pounds this increase in supply of pounds if the conversion was into us dollars would show as an increase in demand for dollars so an increase in supply of pounds from uk consumers is reflective of an increase in demand for foreign assets goods and services so we’re imagining here that this is not pounds it says converting into dollars instead okay foreign goods assets and services so the relative rates of interest do have a significant influence on the currencies themselves so what about if we look at trade factors now a higher relative net export value so what you’re looking at here is which economy is more of a net exporter so which economy is actually generating one way you think of this because net exports are just exports minus imports so which economy has a higher revenue from trade because trade revenue so net export value is a measure of international demand because the higher the net export value the more goods have been sold in that currency so if there is a hundred million let’s say and of course it would be a lot more if there was a hundred million dollars worth of goods sold by the us that is 100 million dollars worth of u.s which has been demanded by the rest of the world because in order to sell those products another country a consumer in another country had to purchase that and convert out of their domestic currency in order to purchase that product that asset or that service in us dollars now i did just say that a higher export revenue is indicative of more products or services or assets sold but of course technically speaking you could sell the same number of goods services or assets but at a higher price and generate higher export revenues either way it doesn’t really matter because in dollar terms in monetary terms the value has increased so there are more dollars still being demanded when export revenue increases whichever way you cut it so what about a change in income for major foreign trade partners so you can see higher income equals high demand for goods and services and foreign direct investment if you were to take trade partners for example like china and australia we can see that china accounts for a huge number of australian exports so the health of the chinese economy and the health of the chinese consumer is actually quite important in terms of export revenue generated by australia so if for example there is a large change in income for the chinese consumer so in this case let’s take the chinese consumer and the chinese consumer has got now more money because they have generated higher incomes their propensity to spend may actually increase so now with a higher income higher disposable income the chinese consumer may decide to buy two cars instead of one and therefore that increase in spending because of a greater disposable income will feed through to australian exports now most exports from australia to china are commodities but that principle applies all over the world to all of the different interconnected economies and we mentioned commodities this doesn’t have to just be the consumer of course this can be business when we looked at the three pillars of an economy previously government consumer and business it may be businesses that have greater incomes in china and those businesses may be buying commodities from australia and they decide to expand operations and the quantity of commodities they end up purchasing from australia goes up because they have generated higher incomes in the business and therefore they are expanding operations this also holds true for innovations and inventions so you could think of new quality products being brought to market for export can increase demand for uk exports in this case and innovations perhaps an increase in the quality of the exports of the goods and services or assets increasing demand for exports and as a result increasing demand for pounds so the conversion out of dollars into pounds you can also have government debts now this is something we’ll look at later on in the course but government high levels of government debt are inflationary and this actually can see especially if total debt gets too high investors and consumers could actually lose confidence in that economy and as a result may be willing to convert out of that currency so selling of the currency in an economy where debt is too high and conversely if there are low levels of debt this may generate high confidence in the economy and as a result this would be deflationary low levels of debt are generally speaking deflationary and as a result demand for that currency of that economy would increase high levels of debt can also bring down interest rates so usually you will need low levels of interest rates in order to be able to service high levels of public debt so this again would be negative for the underlying currency shifting supply to the right of that currency increasing the number of people prepared to convert out of the underlying currency if there are large national debts in place keeping interest rates suppressed international competitiveness is also another factor in demand and supply movements in currencies let’s consider for example a uk business so converting out of pounds a uk business they are setting up a new big operation and they decide that they can get lower labor costs in the us so demand for foreign goods services and assets increases from the uk company and at the same time supply of pounds increases as they convert out of pounds and set up the offices in the us instead and all of the labor costs that they incur with their staff in the u.s are paid from pounds they will be converting out of pounds into u.s dollars in order to pay those labor costs in order to cover any consumption and investment that goes along with those new operations in the us and that is the same for high labor flexibility and also higher labor skills so lower labor costs higher labor flexibility and higher labor skills equal higher demand for currency and vice versa it doesn’t have to be just for businesses of course it can also be for the consumer it may be the case that an american consumer this time instead of a uk business is looking to convert into pounds why because they may have a health problem and they decide that they can get better treatment let’s say and all of these are just examples but they may decide they can get better treatment in the uk and so they’re prepared to fly to the uk and pay for private health care and they will be converting out of their u.s dollars and converting into pounds so demand for the pound increases at the same time supply of the dollar increases as well okay and finally we have speculation so of course speculation on all of the previous factors can in and of itself cause movements in the supply and demand of currency and we know in fact speculation does cause moves in the foreign exchange markets