Introduction
The foreign exchange (forex) market is influenced by a complex interplay of economic, political, and financial factors. Unlike technical analysis, which focuses on historical price movements, fundamental analysis seeks to understand the underlying reasons for currency fluctuations. This approach is essential for long-term traders, investors, and policymakers who need to assess currency strength based on macroeconomic conditions.
In this article, we will explore three fundamental factors that significantly impact forex price movements: interest rate differentials, economic performance, and political stability. To illustrate these concepts, we will analyse the behaviour of the following currency pairs: USD/JPY for interest rate differentials, EUR/USD for economic performance, and USD/CAD for political issues. Additionally, we will examine how these factors have influenced major forex pairs since 2022.
Interest Rate Differentials: The Case of USD/JPY
Interest rates are one of the most significant drivers of forex prices. When a country offers higher interest rates compared to another, its currency typically appreciates because investors are drawn to higher returns on their investments. This principle, known as the interest rate differential, plays a crucial role in determining exchange rate movements. Traders often monitor central bank policies to anticipate changes in interest rates, as these shifts directly influence currency demand.
A prime example of how interest rate differentials affect forex is the USD/JPY pair. The United States and Japan have historically maintained different monetary policies. The US Federal Reserve (Fed) adjusts interest rates to control inflation and manage economic growth, while the Bank of Japan (BOJ) has kept rates near or below zero to stimulate economic activity and combat deflation.
Since 2022, the Fed has been raising interest rates to combat inflation. The federal funds rate increased from 0.25% in early 2022 to 5.50% by mid-2023 1. In contrast, the BOJ has maintained its negative interest rate policy at -0.10% as part of its ongoing stimulus measures 2. This growing interest rate differential has made the US dollar more attractive to investors, driving the USD/JPY exchange rate higher from around 115 in early 2022 to approximately 158 by January 2025 3.