Human history is defined by competition over valuable resources through trade agreements, political treaties, colonisation efforts, and brutal wars. Nowadays, countries competition over resources is made by using the power of their local economies.
This power is represented by the global value of its national currency in the international trade arena. Therefore, the currency strength plays a cardinal role when measuring dominance in the global economy, as well as in international politics.
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What is Currency Strength?
Currency strength is the relative purchasing power of a national currency when traded for products or against other currencies. It is measured in terms of the quantity of goods and services purchased and the sum of foreign currency received in exchange for one unit of the national currency.
Normally, increasing the economic value of a currency will enable its spenders to purchase larger amounts of products, while its earners will enjoy further financial empowerment with more valuable income.
A currency’s strength is determined by the interaction of a variety of local and international factors such as the demand and supply in the foreign exchange markets; the interest rates of the central bank; the inflation and growth in the domestic economy; and the country’s balance of trade. The currency strength can be evaluated in three dimensions:
- Value: the relative purchasing power for goods and services in comparison to foreign currencies
- Utility: the relevance as a financial valuation and exchange device in foreign economies
- Reserve: the acceptability in international trade, driving foreign central banks to hold reserves
As the local production activities add further value to the country’s economy, higher purchasing power encourages spending. The surge in the supply and demand stimulates import and export, flourishing the international trade volumes.
The national currency gains utility in the trade-partner countries, which, in turn, drives their central banks to create reserves for it. Such acceptability enables commerce via a direct exchange of currencies without the mediation of a stronger currency like the U.S. Dollar.
It also provides room for manoeuvre in case a trading partner’s currency value fluctuates due to external circumstances. As a result, the national currency strengthens in the money markets and gains value in the Forex pairs.
The U.S. Dollar is currently considered the strongest currency in the world. The U.S. economy has the largest consumer market, and the USD serves as the primary trade and reserve currency all around the globe.
Around 60% of the world’s central bank reserves, 40% of debt, 90% of forex trades, and 80% of global trade is denominated in dollars. When the world experiences a crisis, everyone looks to the U.S dollar as a shelter from risks. However, many countries and foreign companies borrow in U.S dollars and earn revenue or taxes in their domestic currencies; dollar strength increases default risk.
How to Calculate the Currency Strength?
In the domestic economy, the strength of the national currency is calculated as the purchasing power when buying locally produced goods and services. It is based on income and wages reports which reveal the nominal earnings of the citizens.
The nominal income value is then adjusted to the inflation rate of the observed period to find the real income value. The real income figure represents the true economic value of the income amount in the pre-inflation economic conditions.
In the foreign exchange markets, a currency’s strength is measured in relation to foreign currencies in the Forex currency pairs. For example, EUR/USD currency pair is comprised of the U.S. Dollar and the Euro, the two largest reserve currencies in the world.
Their competition depicts the global economy’s preference and trust towards their respective economies. A variety of factors can affect the FX rate of the Euro-Dollar, including their internal economic climates, trade performances, and regional conditions.
On the other hand, when it comes to the currencies of the emerging markets like Brazil or China, their strength is measured against one of the major reserve currencies. For example, when the Chinese Yuan increases against the U.S. Dollar in the USD/CNY currency pair, the Chinese economy would be getting stronger and gaining more power in the global arena.
There are also currency strength indicators which gauge the overall strength of a currency in the global financial markets. Notably, the U.S. Dollar Index (“Dixie”) is the most popular currency strength meter and has a tradeable derivatives in the Intercontinental Exchange.
The USD Index compares the strength of the American Dollar against the currencies of the major trading partners of the U.S. It calculates a weighted average price of the USD currency pairs with Euro, British Pound, Japanese Yen, Canadian Dollar, Swedish Krona, and Swiss Franc. The Euro is the strongest currency in the Dixie with 57% weight, while the weakest currency is the Swiss Franc with only 3.7% weight.
Currency Strength as an Economic Indicator
The strength of a national currency can affect the country’s domestic economy and international trade activities in various ways. As a lagging indicator, the implications of a strengthening or weakening currency value might differ depending on the economic conditions as well as the economic policies.
Currency strength in the domestic economy refers to its purchasing power over locally produced goods and services. When the economy is stagnant, the central bank can cut the interest rates to reduce currency strength.
Decreasing borrowing costs accelerates production, and the national Gross Domestic Product (GDP) grows. Enhanced income and wages of the citizens translate into increased spending and consumer demand, leading to the inflation of consumer prices and allowing the businesses to enjoy higher corporate profits. Expansionary stimulation of the domestic economic activity helps the currency strength to increase in an organic fashion.
However, continuous strengthening of the currency can inflate the cost of living above affordable levels. Salary demands will rise accordingly, and the companies won’t be able to sustain profitability with high wages and expansion costs at the same time.
Lay offs will start and lead to higher unemployment rates, causing stagflation in the economy with high inflation and unemployment. The central bank will prevent this by slowing down the economy with an interest rate hike that would increase the currency strength.
As the currency strength increases, importers will be able to purchase larger quantities with the same nominal amount or the same quantity with a less nominal amount. At the same time, the exporters will enjoy added real value to their nominal income. However, the effectiveness of the currency strength is based on the economic policy adopted by the country.
For example, a country that adopts export-led growth, like China, would prefer a low currency strength to maintain the cost-effectiveness of the locally produced goods and services and to continue attracting foreign buyers. Thus, a relatively weaker currency will enhance its exports, and the Chinese economy will grow by receiving foreign currencies. On the other hand, countries that aim for import-led growth, like the U.S., care to have a strong currency value, which would enable them to enjoy strong purchasing power so they can import products in large quantities.
How to Trade with Currency Strength?
Currency strength is the main determinant of the price rates of the Forex currency pairs in the financial markets. As many short-term traders prefer news trading strategies, the economic events that influence a currency’s value can create significant market turmoil.
Such economic events include the central bank meetings and the interest rate decisions as well as the releases of economic reports such as Gross Domestic Product (GDP), Consumer Price Index (CPI), Unemployment Rate, Employment Change, and Balance of Trade.
When an economic event is about to happen, the previous results and the forecasted figures of the report or decision are published in the economic calendar. The market sentiment becomes salient as the long-term investors thoroughly analyse these forecasts and take their positions.
If the actual result is congruent with the expectations, the currency strength can increase or decrease accordingly, and cause the respective national currency to gain or lose value in the currency pairs.
However, if the outcome takes the investors by surprise, extreme volatility can occur as both investors and traders would have to take more time to assess the details of the report and determine what the central bank might infer from the data.
** Disclaimer – While due diligence, care and research has been undertaken to compile the above content, it remains an informational and educational piece only. None of the content provided constitutes any form of trade or investment advice or recommendation and should not be construed as such.
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