What Moves Exchange Rates?

The Forces Behind Currency Fluctuations

Exchange rates — the prices of one currency relative to another — are among the most closely watched indicators in global finance. They influence everything from international trade and investment to inflation and tourism. Yet the factors that move exchange rates can appear complex and sometimes unpredictable.

Behind every tick on a currency chart lies a network of economic fundamentals, political developments, and market psychology. In this article, we’ll explore the key drivers of exchange rate movements — from macroeconomic data and central bank decisions to news shocks and investor sentiment.

1. The Basics: Supply, Demand, and Market Expectations

At its core, an exchange rate reflects the supply and demand for two currencies. If investors, businesses, or governments want to hold more of one currency than another, its price rises. Conversely, if demand falls, so does the currency’s value.

These flows of demand and supply are influenced by expectations about future economic and financial conditions. Traders don’t just react to what’s happening today — they try to anticipate what will happen tomorrow. This forward-looking nature of markets means expectations can move exchange rates just as much as actual data.

For example, if markets expect the U.S. Federal Reserve to raise interest rates, investors may buy dollars in anticipation, even before the policy decision occurs. The dollar rises not because of what the Fed did, but because of what markets expect it to do.

2. Interest Rates and Monetary Policy

The Interest Rate Differential

One of the most powerful drivers of currency values is the interest rate differential — the gap between interest rates in two countries. Higher interest rates attract investors seeking better returns on bonds or deposits, increasing demand for that country’s currency.

For instance, if the European Central Bank (ECB) keeps rates low while the Bank of England raises rates, investors might shift funds from euros to pounds. This capital movement pushes the pound higher and the euro lower.

Central Bank Decisions

Central banks are therefore among the most influential players in the foreign exchange (FX) market. Their policies affect not only interest rates but also market expectations about future economic conditions.

Key central bank actions that move exchange rates include:

• Rate hikes or cuts — Directly change the return on holding a currency.

• Forward guidance — Statements about future policy can shift expectations dramatically.

• Quantitative easing or tightening — Buying or selling government bonds affects liquidity, yields, and investor behavior.

• Currency interventions — In rare cases, central banks buy or sell their own currency to influence its value.

For example, when the Bank of Japan (BOJ) maintains ultra-low interest rates while the U.S. Federal Reserve tightens policy, investors tend to borrow cheaply in yen and invest in higher-yielding dollar assets — a strategy known as the carry trade. This dynamic can push the yen lower and the dollar higher.

3. Inflation and Purchasing Power

Over the long term, exchange rates tend to reflect differences in purchasing power — the amount of goods and services a currency can buy. According to the Purchasing Power Parity (PPP) theory, currencies should adjust to equalize prices across countries.

If inflation in one country rises faster than in another, its goods become relatively more expensive, reducing export competitiveness. Over time, its currency may depreciate to restore balance.

However, in the short to medium term, inflation’s effect on exchange rates depends on monetary policy reactions. If a country experiences rising inflation and its central bank responds with aggressive rate hikes, the currency might strengthen despite higher prices — as investors anticipate higher returns.

4. Economic Growth and Trade Balances

GDP Growth and Investment Flows

Strong economic growth often attracts foreign investment, increasing demand for the domestic currency. Investors tend to favor countries with robust growth prospects, stable governance, and healthy corporate profits.

However, growth alone doesn’t guarantee a stronger currency. If growth is driven by government spending and rising inflation, investors may fear instability or policy tightening down the road, which could have the opposite effect.

The Role of Trade Balances

A country’s current account balance — the difference between exports and imports — also affects its currency. A trade surplus means more foreigners are buying the country’s goods and, by extension, its currency. A trade deficit, conversely, implies greater demand for foreign currencies.

For example:

• A large U.S. trade deficit tends to weaken the dollar over time, as Americans buy more foreign goods and pay in dollars, which are then sold for foreign currencies.

• Meanwhile, countries like Germany or China, with persistent surpluses, often experience upward pressure on their currencies (though central banks sometimes offset this by buying foreign reserves).

5. Political Stability and Geopolitical Risks

Currencies thrive on stability and confidence. Investors seek safe and predictable environments for their money. Political turmoil, social unrest, or geopolitical conflict can undermine confidence and trigger capital flight.

Examples include:

• Brexit (2016): The pound sterling fell sharply after the UK voted to leave the EU, reflecting uncertainty about future trade and investment.

• Russian invasion of Ukraine (2022): The Russian ruble initially collapsed as sanctions hit and foreign investors exited the market.

• U.S. government shutdowns or debt-ceiling crises: These episodes can temporarily weigh on the dollar as investors assess fiscal risks.

On the flip side, currencies from politically stable nations — such as the Swiss franc or U.S. dollar — often benefit during global crises, as investors seek safe-haven assets.

6. News, Data Releases, and Market Sentiment

The Power of News

In today’s interconnected world, news events can move exchange rates instantly. Economic data releases — such as employment numbers, inflation reports, or GDP figures — provide real-time insights into a country’s economic health.

For instance:

• A stronger-than-expected U.S. jobs report (Nonfarm Payrolls) often boosts the dollar, as it suggests robust growth and potential rate hikes.

• Conversely, weaker data can trigger selling, especially if markets expect the Federal Reserve to ease policy.

Market Psychology and Sentiment

Exchange rates are not determined solely by fundamentals. Investor sentiment — optimism, fear, or herd behavior — often amplifies movements. Traders react to headlines, price momentum, and perceived trends.

In financial crises, for example, panic selling can cause overshooting — where a currency falls far below its fundamental value. Later, when confidence returns, the currency may rebound quickly.

This behavior is described by the “overshooting model” developed by economist Rudiger Dornbusch, showing how exchange rates can react excessively to news before stabilizing.

7. Speculation and Financial Flows

The foreign exchange market is dominated not by trade in goods and services, but by financial transactions. Over 90% of FX trading volume comes from investors, hedge funds, and banks positioning for profit or hedging risk.

Speculative activity can therefore amplify currency swings. When traders collectively expect a currency to rise, they buy — reinforcing the trend. This self-fulfilling mechanism can create momentum effects that push currencies beyond their fair value, at least temporarily.

Large institutional investors also move funds between global markets based on expected returns, risk appetite, and policy changes. For example:

• When U.S. Treasury yields rise, global investors may shift capital into dollar assets.

• When emerging markets offer higher yields and political stability, capital flows toward them, supporting their currencies.

8. Commodity Prices and Resource Currencies

For countries that export commodities such as oil, gas, or metals, currency values often track commodity price cycles.

• The Canadian dollar (CAD) is closely linked to oil prices, since crude exports make up a major share of Canada’s trade.

• The Australian dollar (AUD) and New Zealand dollar (NZD) often move with global demand for minerals and agricultural goods.

• The Norwegian krone (NOK) also fluctuates with oil markets.

When commodity prices rise, these nations earn more export revenue, boosting demand for their currencies. When prices fall, their currencies tend to weaken — a reflection of deteriorating terms of trade.

9. Global Risk Appetite and “Safe Haven” Currencies

Financial markets often move in cycles of risk-on and risk-off sentiment.

• In “risk-on” periods, investors seek higher returns in emerging markets or riskier assets, selling safe-haven currencies like the dollar, yen, or Swiss franc.

• In “risk-off” phases — such as during geopolitical crises or stock market downturns — investors rush back to safety, buying those same currencies.

This dynamic explains why the U.S. dollar often strengthens during global uncertainty, even when U.S. fundamentals are mixed. The dollar remains the world’s reserve currency, backed by deep financial markets and global trust in U.S. institutions.

10. Structural and Long-Term Factors

Beyond short-term news and data, structural trends shape exchange rates over years or decades:

• Demographics: Aging populations may reduce growth and investment, weakening a currency over time.

• Productivity growth: Countries with higher productivity gains often see stronger currencies.

• Fiscal policy: High government debt or persistent deficits can undermine confidence in a currency’s long-term value.

• Technological and industrial competitiveness: Innovative economies attract capital and sustain stronger exchange rates.

For example, over the long run, the U.S. dollar has remained dominant due to the size of the American economy, its technological leadership, and the global role of its financial markets.

11. Interventions and Currency Wars

Sometimes, governments or central banks actively intervene in FX markets to prevent excessive appreciation or depreciation. They may buy or sell foreign currencies or impose capital controls.

• China, for instance, has historically managed the yuan’s value to maintain export competitiveness.

• Switzerland’s central bank has intervened repeatedly to prevent the Swiss franc from becoming too strong during global crises.

Such actions can temporarily stabilize exchange rates, but sustained interventions often face limits. Market forces eventually reassert themselves, especially when economic fundamentals diverge.

12. The Modern Era: Algorithms and Global Connectivity

In the digital age, currency markets are faster and more interconnected than ever. Algorithmic and high-frequency trading (HFT) now account for a large share of FX transactions, reacting to news and data within milliseconds.

This automation can amplify volatility, particularly during unexpected announcements or low-liquidity periods. For example, “flash crashes” — sudden, sharp moves in exchange rates — have occurred in the yen and pound due to algorithmic triggers and thin trading conditions.

Meanwhile, social media and online platforms spread financial news instantly, influencing market psychology across time zones. The result is a market where information — and speculation — flows continuously and globally.

13. Case Studies: When Exchange Rates Moved the World

a. The Dollar and the 2008 Financial Crisis

During the global financial crisis, the U.S. dollar paradoxically strengthened, even though the crisis originated in America. Investors sought liquidity and safety, underscoring the dollar’s safe-haven status.

b. The Eurozone Debt Crisis

Between 2010 and 2012, fears over Greek and Italian debt led to euro weakness. The turning point came when ECB President Mario Draghi pledged to do “whatever it takes” to preserve the euro — a signal of decisive central bank support that calmed markets and strengthened the currency.

c. Japan’s Yen Surges

In times of global stress, the yen often appreciates due to the unwinding of carry trades. For instance, after the 2011 Tōhoku earthquake, repatriation of Japanese assets caused the yen to spike, despite the domestic crisis.

14. How Traders and Policymakers Watch the Market

Central banks and governments monitor exchange rates closely because they affect inflation, competitiveness, and financial stability. A stronger currency can reduce import prices and inflation but hurt exporters; a weaker one can do the opposite.

Policymakers therefore strike a balance: most advanced economies allow floating exchange rates, intervening only in exceptional cases, while others adopt managed floats or pegs.

For market participants — from multinational corporations to hedge funds — exchange rate risk management is essential. Tools such as hedging, forwards, and options allow them to mitigate exposure to currency swings.

15. Conclusion: The Dance of Fundamentals and Perception

Exchange rates are ultimately the product of both economic fundamentals and human psychology. Interest rates, inflation, and trade balances provide the underlying rhythm, while news, expectations, and sentiment create the melody.

In the short term, currencies can move violently on headlines or speculation. But over the long term, they tend to align with economic realities: productivity, policy credibility, and purchasing power.

Understanding what moves exchange rates requires not just tracking data, but interpreting how markets perceive that data. In a world where capital flows at the speed of light and information never sleeps, the foreign exchange market remains a living reflection of global confidence, competition, and change.