Inflation and Forex

Table of Contents

The currency market, popularly known as the Forex, is highly volatile. Instability in the currency market doesn’t always translate into complex trading options. It is volatility that creates liquidity in the Forex market. The more the liquidity, the higher your chance of reaping whirlwind gains on your investment. But inflation retards the forex market and puts currency traders in a tough spot.

The soaring worldwide inflation has precipitated a Forex crisis and sent all previous financial analyses into a tailspin. Forex is witnessing a tough time as investors, spooked by the market, are gravitating towards safe havens such as gold.

What is Inflation?

When a currency loses its value, we call it inflation. The devaluation of money leads to an increase in prices over a period of time. The rise in the price of commodities, or the depreciation of money, translates into the low purchasing power of people. When people’s purchasing power is compromised, the market loses its equilibrium as the demand crashes. Loss of purchasing power triggers inflation.

What we are witnessing around the world is maybe a prelude to a recession. Spooked by the events unfolding around the world, investors have begun taking refuge in safe areas like gold and oil. The fear of recession has gained currency over the past few months because Russia invaded Ukraine and China’s aggressive military posturing in the Taiwanese straits. The economic blockade put on Ukraine by Russia can cause food shortages worldwide.

If all these events are read together, the world seems poised to step into a recession. The inflation we are witnessing is a reaction to the fear of recession.

How Does Inflation Affect Forex?

Forex is nothing but an over-the-counter digital marketplace where currencies are traded. Currency trading is done in pairs. The price of one currency is always gauged in relation to another currency. We can’t trade currencies without a base and a quote currency.

The price of a currency is determined by market forces and the economic health of the country to which it belongs. When you buy a particular country’s currency, you buy a share of that country’s economy. In simple words, buying a currency signifies your trust in the strong economic development of that currency’s country. When you lose faith in a country’s economy, you sell that country’s currency. But when you see the economic prospect of a country bright, you buy their currency.

Inflation, as stated above, sends economies into a tailspin. The soaring price of commodities and erosion in people’s purchasing power corrodes currency value. This triggers a crisis in the Forex market. Investors take to their heels and switch their investment in safe commodities like gold which, by and large, remain stable and can withstand any economic shock.

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The Unfolding Economic Situation in The World at This Moment

The Economist magazine is predicting a recession for the American economy by 2024. The twin whammy of pandemic-induced demand and supply collapse and geopolitical instability in Europe and Asia are pushing the world economy towards a contraction. The American recession, whenever it comes, is believed to be mild but will disrupt the world economy. Whenever the U.S. sneezes, it is believed that the world catches a cold.

2022 has been a tough year for the Federal Reserve when the Federal Open Market Committee has effected many dramatic changes to the USA’s monetary policy in a desperate attempt to bring inflation at par with its long–term target of around 2 percent. The Fed is trying to contain inflation by raising interest rates. But this effort to control inflation is, counterintuitively, setting the wheel of recession in motion. Rising interest rates increase the borrowing costs for companies and consumers. Companies try to offset the increased cost of production by raising the price of commodities, while consumers try to consume less to keep their budget in balance.

A situation like this is a recipe for economic disaster, which at the moment is playing out in the United States. The American economy, by virtue of its size, affects the economy across the world. A slide in the U.S. market has a domino effect elsewhere as the dollar is the currency in which the world mostly trades.

Is There No Hope?

Consumer Price Index in the States rose to 8.6 percent in May – a .3 percentage point rise compared to April. CPI, on a month-over-month basis, increased by one percentage point compared to April.

The CPI data confirms our worst fear: Inflation in America hasn’t peaked yet and remains quite high. If the CPI remains high without peaking immediately, recession, though a mild one compared to 2008, will be inevitable.

Inflation And The Forex Market

The rate of inflation in a country can have consequences on the value of that country’s currency.

Inflation in the economy usually has a net negative effect on the currency. A high inflation rate can impact the country’s exchange rate with other countries negatively. A country always tries to tackle inflation by hiking interest rates, which in turn dampen the market. Lower interest rates spur economic growth by unleashing consumer spending.

What we are witnessing right now across the globe is a race to keep the interest rates higher to tame the accelerating inflation rate. Higher interest rates are taking a toll on the currency market as currency values are weakening, leading to capital flight from the currency market.

Forex Opportunity During an Inflationary Period

As governments try to slow inflation, they increase interest rates, which strengthens the currency.

This is very clear on the USD against major currencies, especially EUR and JPY.

Historically, slowing down inflation by increasing interest rates takes around one year to finally work out, so there is still an opportunity to join the USD bullish trend.

USD/JPY is approaching a key supply level from 1997, and we can expect a pullback from that area, providing an opportunity to join the trend.

During inflationary times, gold and commodities tend to strengthen as people look for safe assets to protect their capital. We have not seen yet gold perform this way, but buying on key supports and building a long-term investment in gold may be a good strategy.

Way Forward

The governments will have to strike a balance between inflation and interest rates. At this point in time, we need a massive infusion of capital into the economy. It could be done if governments start massive public investments to stimulate demand and generate jobs. Only public investment can stabilize market sentiment. Furthermore, the world leaders will have to find a way to stop the war in Ukraine and desist China from invading Taiwan. The world economy is in no way prepared to handle geopolitical instability immediately after pandemic-induced disruption in the supply chain.

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Inflation and Forex - The Impact on the Currency Market | the5ers Blog (2024)