Human history is defined by competition on valuable resources through trade agreements, political treaties, colonisation efforts, and brutal wars. Nowadays, countries competition on 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 the dominance of a country in the global economy as well as international politics.
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 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. Taking all factors into consideration, 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, drive 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 as 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, therefore 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 derivative ETF in the Intercontinental Exchange (ICE: DXY).
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 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 strong currency value which would enable them to enjoy a strong purchasing power that enables to import products in large quantities.
Purchasing Power Parity
Purchasing Power Parity (PPP) is an important macroeconomic metric used to measure currency strength. PPP is a theory that compares the cost of a ‘basket of goods’ in different countries using their respective local currencies.
For economists, PPP helps in comparing standards of living as well as economic productivity of different countries. PPP is also very important in international trade as it helps in determining the best places to shop for the best prices of various products.
The overall concept of PPP is based on the law of ‘one price’: this essentially means that the price of a particular basket of goods should be the same in different locations if all things, such as tariffs or transaction costs, are held constant. For instance, if the price of a basket of goods in the US is $100 and the same goes for £50 in the UK, then $1 should be equal to £0.5.
How is PPP Calculated?
The standard formula is as follow:
S = P1/P2
S = Exchange rate of currency 1 to currency 2
P1 = Cost of the basket of goods in country 1
P2 = Cost of the basket of goods in country 2
The calculation of Purchasing Power Parity is based on the assumption that products are priced in US dollars around the world. When calculated, PPP illustrates the rate at which the US dollar needs to be exchanged in a relevant country so as to purchase goods and services in the local currency.
Compared to the exchange rate, PPP is very effective in assessing the economic state of any country. It is relatively stable and accounts for differences in levels of wages in different countries. It helps give an accurate picture of the purchasing power of consumers in different countries.
However, the Purchasing Power Parity computation has a few drawbacks as well. The metric does not take into account aspects such as market competition, transport costs, and government intervention.
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 most 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.
Why Trade Currency Strength Reports with AvaTrade?
In Forex markets, the currency strength is the decisive factor for the foreign exchange rate of a currency pair. Considering most traders start their trading journey with FX pairs as they grasp the basics of trading and the macroeconomic factors that influence the markets, AvaTrade created a comprehensive toolkit to equip currency traders with state-of-the-art tools.
- When is the next Currency Strength report?
Check the AvaTrade economic calendar to find all economic events for each currency and mark them in your calendar!
- What can happen to the markets?
Whether your favourite currencies rise or fall against others, you can use CFD trading to open Long or Short positions with lower margin requirements.
- Do I have any risks?
Financial trading comes with its own undeniable risks; however, our unique AvaProtect risk management tool will enable you to hedge with options on the spot!
- What if I’m not in front of my computer?
Download our AvaTradeGO mobile trading application and access the markets whenever there is a report that can affect currency strengths.
- Can I ask for your help?
AvaTrade’s award-winning support team is ready to provide assistance for Currency Strength reports and all other trading matters via chat, phone, and email.
Now that you know what affects the currency pairs in its essence, join the global arena of the Foreign Exchange and realise your potential in a market that has $5 trillion trading volume every day!
Currency Strenght main FAQs
- How is the strength of a currency determined?
A high exchange rate does not necessarily indicate a strong currency. The relative strength of a currency is seen over a long period of time. Changes are determined by supply and demand, as well as inflation and interest rates, among other things. Over a long period of time the British pound has become weaker as the British Empire has waned, yet the pound remains a stronger currency than the US dollar. And even though 1 yen is worth a little less than 1 US penny, over the long-term the yen has been consistently strengthening against the US dollar, going from an exchange rate of 300 yen to 1 USD in the early 1970s to the current exchange rate of just over 100 yen to 1 USD.
- What does it mean when a currency is stronger?
What precisely do we mean when we say that one currency is stronger than another? Generally, we are referring to the currency’s strength versus a specific other currency. So, the USD could at the same time be strong versus the GBP, but weak versus the JPY. The relative strength and weakness of a given currency versus a rival is influenced by a number of factors, but the most common are the interest rates of each country, the trade balance of each country, and the perceived stability of the currency and the governments.
- Is it a good thing to have a strong currency?
There are both pros and cons to having a strong currency. When a currency is strong it is less expensive, relatively speaking, to purchase the goods and services from the country with the weaker currency. Conversely demand for the goods and services in the country with the strong currency will typically decline because those goods and services are more expensive to the countries with weaker currencies. On a broader scale a strong currency for a long period of time could lead to businesses moving overseas to lower the price of their goods and services to other countries.
See a trading opportunity? Open an account now!