Six Factors Affect International Currency Rates

The most important influences on currency values are:

1. Interest rates: As a rule higher interest rates lead to higher currency prices [and vice versa]
2. Inflation rates: Higher inflation tend to lead to a weaker currency. This general rule doesn't apply when the rate of inflation is leading a county's central bank to raise interest rates. in that case, despite higher inflation, the markets are likely to bid up that county's currency as they expect interest rates there to continue to rise.
3. Current account status: Countries that tend to export more than they import tend to have stronger currencies than countries that import more than they export. This relationship is soft, however, because some countries, such as Japan, purposely keep their respective currencies weak by selling them in the open market just to keep their exports high. These countries don't export their currencies; instead, their central banks sell them into the open market just to keep their exports high. These countries don't export their currencies; instead, their central banks sell them into the open market by making trades just like any other trading desk. The net effect is to increase the amount of a country's currency that is floating in the markets, thus decreasing its value to indirectly affect the balance of trade.
4. Budget status: Countries with budget surplus, again, as a general rule, tend to have stronger currencies than countries with budget deficits. This rule also is soft, because it doesn;t hold up all the time. For example, the United States has a chronic budget and current-account deficits, but the U.S. dollar experiences long rallies in which its strength is quite impressive.
5. Political stability: Along with interest rates and economic fundamentals, politics are more than likely the most consistent determinants of the exchange rates that are quoted on a regular basis. Despite a fairly strong economy, an otherwise strong dollar during the Clinton administration suffered during the Monica Lewinsky scandal.
6. Foreign policy: The U.S. dollar's status as the world's reserve currency was damaged by the war in Iraq. In fact, the dollar was already weakening before the war started as traders feared Bush administration policies, such as lower taxes and potential for increased government. The 9/11 attacks, with their negative effects on the U.S. economy and the spiraling costs of the war indeed led to a series of U.S. budget deficits, and the dollar continued to weaken into 2008.

From Duarte, Trading Futures for Dummies