Every currency trading in the global foreign exchange market has a relative value and, by implantation, a strength that serves as a reference point for international trading, exchange, and economic activities. If you trade forex on Tradingview, for example, you’ll notice that some currencies are stronger than others, as shown by their exchange rates and traders’ sentiments. In this article, you’ll learn what the strength of a currency is, why currencies have different strengths, and the factors that affect the strength of currencies.
What is the Strength of a Currency
Picture this for a moment. You want to exchange a foreign currency for your local currency or vice versa. The bank or licensed exchanger then gives the exchange rate, which shows that you have to pay or receive more in your local currency than you would have a few days back. What it means is that the foreign currency is stronger than your local currency, maintaining a constant price despite the fluctuations of your local currency.
The strength of a currency means different things, depending on the context. In international or local trade, it refers to the purchasing power of the currency, but for foreign currency (forex) exchange, it refers to an aggregate of economic indicators that tells the economic strength of a country and, by implication, its currency.
In simple terms, the strength of a currency refers to the number or amount of goods or quality of service that a certain amount of a currency can purchase and the amount of a foreign currency exchanged for one unit of the currency.
These could be fundamental news, interest rates, and even economic stability.
The strength of a currency is calculated using fundamental and price-based methods.
What Affects the Strength of a Currency (measuring by fundamental data)
When calculating the strength of a currency using fundamental data, there are twenty (20) factors that impact it and are considered based on their impact. These are:
Sovereign Bond Yields Inflation
Employment Rates Interest Rates
Central Bank Reserves Political Trends
Central Bank Balance Sheets Money Supply
Quantitative Easing Government’s Trades Balance
Government’s Debt Government’s Surplus or Deficit
Index, and Stock Market Returns Government’s Public Spending
Commodity Returns GDP Growth Rates
Balance of Payments Interest Rate Differentials
Monetary and Fiscal Policies Business Surveys
Each indicator is assigned +1 or -1 based on the current state. Positive states get the former, while negative states get the latter. In the end, the total score is then considered the strength of the indicator.
The US Index Is The Most Popular Currency Strength Meter
The US Dollar Index (sometimes represented as USDX, DXY, DX) measures the USD’s strength against certain currencies. The US Dollar index is sometimes called the “Dixie” informally. The currencies measured against the US Dollar are the Euro (EUR), Japanese Yen (JPY), Pound Sterling (GBP), Canadian dollar (CAD), Swedish krona (SEK), and Swiss franc (CHF). The US Dollar maintains a relative weight to these currencies. The index increases when the US Dollar rises and decreases when it falls. The Dixie is probably the most popular index today; it has a tradable exchange-traded fund (ETF) trading on the Intercontinental Exchange (ICE: DXY).
The Dixie is the most popular currency strength meter because it has most of the world’s strongest currencies. Measuring the US Dollar against these six currencies provides a strong reference point for other currencies to measure their strength. As strength meters go, the Dixie provides the most information.
The US Dollar is The World’s Strongest Currency
Despite having a slightly lower worth than six other currencies, the US Dollar remains the strongest currency in the world. The US Dollar is the most used currency held as reserves worldwide, making over 55% of the world reserves by volume. In addition, the USD accounts for over 90% of the daily trillions traded in the forex market. 40% of debts and 80% of global trade are also held in USD. The USD is the leading currency in the global forex market, and traders measure its strength and performance against other currencies during analysis. The market value of the USD directly or indirectly impacts the value of other currencies, whether or not they are paired with the USD.
The Strength of a Currency Has a Round Cause-Effect Relationship With The Economy
Although the economic condition determines the strength of a currency, the currency’s strength, in turn, impacts certain determinants of the economy. For example, inflation, higher exchange rate, and poor economic growth may reduce the strength of a currency, but investors looking for economic indicators may then consider the low strength of the currency and decide not to invest in the economy. Governments and central banks typically respond by increasing interest rates to stimulate growth. They may also implement similar policies to arrest inflation.
Thus, the strength of a currency is affected and determined by the prevailing economic conditions, but it, in turn, affects the response from the government to stimulate the economy.
You can quickly get an idea of the strength of a currency by checking the quoted price of a currency pair on your broker. But you can further check the economic indicators and get more data. The strength of a currency is an important fundamental indicator of possible price direction; the lower it goes, the more chances of having a price fall in the market as investors lose confidence and begin to sell off. Learn to incorporate this important factor when analyzing the market.
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