Forecasting foreign exchange rates might seem like a difficult endeavor that keeps a myriad of analysts, economists, traders and other prognosticators employed — and constantly revising their forecasts due to the numerous moving pieces and fluctuations in the global marketplace.
After all, the foreign exchange market, also called FX or forex, is the world’s largest financial market, with $7.5 trillion in daily trading. That makes it a very liquid — and volatile — marketplace that trades across the globe and virtually around the clock.
Despite the perceived challenges, understanding how exchange rates are likely to move can help organizations and individuals make informed decisions about when and how to use their money. This understanding can help minimize risks in a global economy where economic changes in one country can create impacts around the world.
Businesses, governments and individuals must understand where currencies trade in relation to one another and where they may move next. It’s helpful for minimizing risks, budgeting and payments purposes to have a forecast for near-term and longer-term trends.
FX risk management tools can help stabilize pricing and offset some volatility. Still, these strategies are not foolproof given the relentless drumbeat of the news cycle and constant connection market participants have in the modern era.
Understanding foreign exchange rate forecasting
Foreign exchange rate forecasting is the process of predicting the future value of one currency in relation to another. This task is crucial for individuals and businesses involved in international trade, investment or travel, as accurate forecasting can help minimize risk.
There are several methods for forecasting exchange rates, each with its own strengths and weaknesses:
Fundamental analysis involves examining economic indicators, such as GDP growth, inflation and interest rates, to determine the intrinsic value of a currency. This method is useful for long-term forecasting as it provides a comprehensive view of a country’s economic health.
Technical analysis focuses on historical price data and trading volumes to identify patterns and trends. This method is often used for short-term forecasting, relying on statistical changes to predict future price movements.
Econometric models combine fundamental and technical analysis, using mathematical and statistical techniques to forecast exchange rates. These models can be highly accurate but require extensive data and expertise to implement effectively.
By understanding and using these different methods, individuals and businesses can make more informed decisions about future exchange rate movements.
How to forecast exchange rates: Key factors to consider
When forecasting exchange rates, you must consider several key factors:
- Economic growth: A country’s economic growth rate can significantly impact its exchange rate. Strong economic growth typically leads to currency appreciation, while weak growth can result in depreciation.
- Interest rates: Changes in interest rates can affect the attractiveness of a country’s currency. Higher interest rates tend to attract foreign investment, leading to currency appreciation, while lower rates can have the opposite effect.
- Inflation: High inflation can decrease the value of a country’s currency, as it erodes purchasing power. Conversely, low inflation can strengthen a currency.
- Trade balance: A country’s trade balance can impact its exchange rate. A trade deficit, where imports exceed exports, can lead to currency depreciation, while a trade surplus can result in appreciation.
- Central bank actions: Central banks play a crucial role in determining exchange rates through monetary policy decisions, such as setting interest rates and controlling money supply. Their actions can have a significant impact on currency values.
By considering these factors, individuals and businesses can better anticipate and understand exchange rate movements.
Forecasting challenge 1: Moving parts and targets
Economic indicators play a crucial role in forecasting exchange rates. These indicators provide valuable insights into a country’s economic health and can help predict future exchange rate movements.
Economic indicators for forex forecasting accuracy
- Gross domestic product (GDP) growth rate: A higher GDP growth rate indicates a strong economy, which can lead to an appreciation of the country’s currency.
- Inflation rate: High inflation can erode the value of a currency, leading to depreciation. Conversely, low inflation can strengthen a currency.
- Interest rates: Higher interest rates attract foreign investment, increasing demand for the currency and leading to appreciation.
- Unemployment rate: A low unemployment rate suggests a healthy economy, which can positively impact the currency’s value.
- Trade balance: A trade surplus indicates that a country exports more than it imports, which can lead to currency appreciation. A trade deficit can have the opposite effect.
- Purchasing power parity (PPP): This theory suggests that, in the long run, exchange rates should adjust to equalize the prices of a basket of goods and services between two countries.
By analyzing these economic indicators, forex traders and analysts can make more informed decisions about future exchange rate movements.
Currency exchange rates forecasting demystified
Exchange rates reflect the economic differences between nations or an economic bloc’s common currency (in the case of the European Union’s euro).
There are many moving parts in the currency data (known as macroeconomic indicators), including national income, economic and money supply growth, inflation, trade balances and other factors for the underlying economy represented by each country’s currency.
Then there’s the concept of PPP, perhaps best illustrated by The Economist with its Big Mac Index, which compares prices of the McDonald’s burger in different countries. The British publication defines PPP as “the notion that in the long run exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services (in this case, a burger) in any two countries.”
In other words, exchange rates will adjust to keep prices of a homegrown burger roughly the same in each country. PPP is one of the most widely used methods of predicting currency fluctuations based on the “law of one price.”
However, The Economist says it’s a better measure of where exchange rates may be heading, highlighting whether currencies may be over or undervalued. It’s not a great measure of where they currently are. Instead, The Economist points to GDP per capita as a better guide to a currency’s current fair value.
Choosing an accurate economic indicator
Fast food aside, various economic factors are constantly compared to one another in real time in the forex market: a currency’s current value is known as the spot rate, while the data built into longer-term expectations informs the forward rate.
The forward rate incorporates monetary policy, expectations and forecasts for the direction of interest rates (borrowing costs) and money supply. The longer view can be helpful for companies looking to avoid FX losses by locking in or hedging payments and other costs against currency swings.
Forecasting challenge 2: Geopolitical influence
Volatility, or the swings in market pricing of a currency pair such as the US dollar vs. the euro, is a major challenge for forecasters and traders alike.
Forex volatility refers to the degree of variation in the price of a currency pair over time. In simple terms, it measures how much and how quickly the price of a currency pair moves. Volatility is a critical factor in forex trading, as it can influence the potential for profit and the level of risk involved.
Geopolitical events such as wars and elections loom large over all markets and can bring about drastic changes in government and public policies.
This has been a big focus for Convera experts, who advise: “With the U.S. doubling down on trade barriers and Europe dealing with structural hurdles, FX volatility will continue to be a reality in 2025. As President-elect Trump’s administration introduces new policy moves, markets will respond swiftly, [and] while political certainty may seem like a stabilizing force, the potential for tariff hikes and tax adjustments suggests that businesses may still need to brace for potential turbulence [in FX].”
Market volatility in focus
Sometimes, these events and other non-correlated factors can reduce the value of one currency against many others, while at the same time strengthening another uncorrelated currency.
The US dollar is a prime example since it’s the world’s reserve currency and often seen as a haven when other global markets (including other asset classes) are hit with high or unexpected volatility.
The factors above can play outsized roles in market sentiment as to whether investors are risk-averse or more risk-tolerant.
It’s more difficult to predict with a high degree of certainty where a particular currency will be in a few days, much less years.
Forecasting challenge 3: Broadening horizons when time matters
There are two popular methods used for creating forecasts, and they are often associated with the time horizon for the investment, hedge or scheduled payment.
Short-term forecasting is often associated with traders utilizing technical analysis. That is, using statistical changes to make valuation and judgment calls on a currency or other asset’s price, often vis-à-vis another investment. Technical analysts use charts to follow trends and momentum during set time frames and use these past moves to create predictions for future moves.
Fundamental analysts often have a longer time horizon; that is, they are looking further into the future. They find intrinsic value through the lens of economic data, often focusing on economic output (GDP), consumer purchasing power and inflation, among other factors. Again, they predicate their analysis on trends extrapolated from data sets.
Some forecasters use both types of analysis to form their strategies and expectations. But again, in this interconnected era, there is always “headline risk,” where unexpected news can move markets quickly. An old saying among risk-averse traders on Wall Street is to “sell first, ask questions later.”
No matter which method, or combination of analyses, that you employ, experts warn that the real world is a volatile place: “Those who forecast the exchange rate for a living quickly discover that the real world is less straightforward than the theory of exchange rate determination might make it appear.”
Forecasting challenge 4: The limits of AI
The complexity of FX forecasts is considered one of the biggest challenges in managing FX risk. It would seem that by processing and analyzing vast amounts of data in real time, artificial intelligence (AI) and machine learning could help.
Indeed, econometric models use mathematics and statistics — and AI-powered data analytics — to model certain economic trends through historical data analysis. Yet, when it comes to making accurate currency predictions, the technology is still in the developmental stage.
Machine learning applications and limitations in forex predictions
Forex traders can use machine learning and data science to create, train and optimize trading strategies. Analysts and risk managers, in turn, can leverage predictive analytics to develop and improve currency exchange rate predictions.
Somewhat ironically, machine learning is stymied by the “small reality” that there are just a few hundred observations of many economic data sets. True market signals can be difficult to identify among the statistical “noise” while unforeseen news often creates the most price variation.
As investors learn and markets evolve, it creates a “moving target for machine learning prediction models.” The very structure of the economy continuously changes, making finance and forex markets a challenging machine learning project.
Best practices for forecasting exchange rates
To accurately forecast exchange rates, it is essential to follow best practices, including:
- Staying up to date with economic news and data releases: Regularly monitoring economic news and data releases can provide valuable insights into potential exchange rate movements.
- Analyzing multiple economic indicators: Using a combination of economic indicators can provide a more comprehensive view of a country’s economic health and help make more accurate predictions.
- Using a combination of forecasting methods: Combining fundamental analysis, technical analysis and econometric models can improve the accuracy of exchange rate forecasts.
- Considering the impact of central bank actions: Central bank decisions on interest rates and monetary policy can significantly impact exchange rates, so it is important to factor these into forecasts.
- Monitoring market sentiment and expectations: Understanding market sentiment and expectations can help you anticipate short-term exchange rate movements and make more informed decisions.
By following these best practices, it’s possible to make more accurate and informed decisions about future exchange rate movements, helping to minimize risk.
From currency forecasting to risk management
No matter how impressive and sophisticated the methodology for forecasts, FX predictions remain incredibly difficult to accurately prognosticate due to the number of data points that can go into the equation. These moving parts almost always ensure some degree of volatility.
Given this difficulty in foreseeing FX fluctuations, it can be helpful to hedge against adverse currency movements, especially with guidance from an experienced partner — like Convera. It’s easier to navigate the foreign exchange market and manage currency risk by gaining visibility to exposures, understanding where risks lie and developing a tailored hedging strategy.
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