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3 key factors that move exchange rates

The largest financial market in the world is the currency market.

$6.6 trillion1 flows every single day between buyers and sellers of currencies and, unlike equity markets, currency markets almost never sleep. They trade 24 hours a day from 5:00pm Sunday (US eastern time) through 5:00pm US eastern time on Friday.

Here is a quick primer on the foreign exchange (Forex or FX) market that makes the global commercial world go round.

What is an exchange rate?

An exchange rate is the price of exchanging one currency for another. Just as a diamond is many times more valuable than a piece of lead, so the currency of one country can be many times the value of another.

What moves exchange rates?

Exchange rates are affected by numerous factors including the perception of stability of the financial system of the issuing currency, the interest rate set by the host country’s central bank and the demand for the goods and services (exports) the country produces.

Let’s look at each of these demand levers in reverse order:

  1. Exports

    In a world of global trade, the more your exports are in demand, the more likely your currency is to appreciate. When a Chinese company buys iron ore from Australia, for example, it will have to pay for it in Australian dollars. So when demand for iron ore is particularly strong both the quantity and value of iron goes up and consequently the demand for Australian dollars to pay for it. The Reserve Bank of Australia (RBA) estimates that for every 10% increase in the Terms of Trade (a technical term for export strength relative to imports), the Australian dollar rises 5-7%.2

  2. Interest rates

    Money doesn’t just flow between countries as part of global commerce. Investment houses also move money between countries in search of higher returns, or yields.

    If you are sitting on a large pool of investible cash, you need somewhere to keep it safely that still earns a return. Investing in share markets may be too volatile and prone to capital loss, so money managers look to bond markets for a more stable return. Governments issue bonds to pay for spending, and the bond return will be based on the interest rate set by the issuing country’s central bank. In highly developed economies where the central bank is well regarded, the likelihood of default is low so the investment is considered very safe.

    Excluding those countries where high interest rates signify high risk, a higher relative interest rate paid on government bonds represents a better return for investors.

    That’s why currency investors keep a close eye on the economic outlook of countries. If a country’s economy is growing quickly, then the interest rates of that country are likely to rise as its central bank looks to prevent it from overheating. Conversely, if that country’s economy is struggling, rates are likely to be cut.

    When interest rates expectations are raised (or lowered) bonds are purchased (or sold), which causes a currency exchange and therefore an appreciation (or depreciation).

    Central banks can use interest rates to reduce demand for their currency as well. By cutting interest rates, they make their currency less attractive relative to peers, pushing its value down as money heads off for better returns elsewhere.

  3. Stability

    There are some times when the relative return of an asset like a bond is not enough to outweigh the risk of losing capital. In times of crisis, US treasuries (bonds) are seen as a safe-haven investment destination. As the most developed economy, the likelihood of the US government defaulting on its bonds is essentially inconceivable, so traders looking for a stable place to park their investment when global economic turmoil is taking place turn to the US dollar.

    In the financial meltdown following the realisation COVID-19 was far worse than feared, the US dollar spiked relative to other countries’ currencies as investors fled to the safety of US bonds.
     

Supply

The above factors affect the demand for a currency, but an equally important component is its supply. Most developed nations try to keep the value of their currency relatively stable to avoid wild swings in the prices of goods and have given their central banks independence and a mandate to set interest rates to ensure the financial system is stable. 

Countries where central banks are at the mercy of politicians, such as Venezuela or Zimbabwe, have experienced hyperinflation as leaders try to print money to fund their government spending. Just as that makes goods increasingly expensive in nominal terms, 2,600,000 Bolivars for a roll of toilet paper for example, so that currency is devalued greatly in foreign exchange markets.

Even more developed countries aren’t averse to devaluing their currencies on purpose - in fact it happens all the time because a lower relative currency makes exported goods more competitive in a global market.

As noted above, interest rates are a key determinant of currency demand but in the ultra-low interest rate environment we are seeing in response to the COVID-19 pandemic, nearly all developed nations have cut their interest rates to near zero.

So, in order to further stimulate their economies, some central banks engage in a process called Quantitative Easing (QE). Under this scenario, the central bank buys newly created government bonds. This both increases the amount of money in circulation and places further downward pressure on interest rates — both factors have a depreciating effect on a currency.

The European Central Bank is currently spending 20 billion euros a month3 on QE, US Federal Reserve is currently buying $US80 billion of US treasuries a month and a further $US40 billion of mortgage-backed securities4, and from November 2020 the Bank of England has purchased £895 billion worth of UK government bonds.5

As economies show signs of recovery, with employment and inflation being key indicators, central banks will eventually pull back on these stimulus measures to prevent their economies from overheating. How, and when, QE tapering and interest rate rises occur should have a large impact on currencies.


 

1https://www.bis.org/statistics/rpfx19_fx.htm
2https://www.rba.gov.au/publications/bulletin/2021/mar/determinants-of-the-australian-dollar-over-recent-years.html
3https://www.reuters.com/article/us-global-europe-idUSKBN2ER0NZ
4https://www.brookings.edu/blog/up-front/2021/07/15/what-does-the-federal-reserve-mean-when-it-talks-about-tapering/
5https://www.bankofengland.co.uk/monetary-policy/quantitative-easing

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