We recently wrote about the importance of managing currency fluctuations. Briefly touching on how politics and economic news such as interest rates and unemployment announcements can alter exchange rates. This article will explore other key factors that cause exchange rate movements.
Before we begin, let's define what an exchange rate is and why it is important: an exchange rate is the price of a nation's or group of nations' currency versus another currency, also known as the domestic and foreign currency. The reason why it's so important is quite simple: it determines the price of a currency versus its counterpart.
So, we've defined interest rates, discussed how best to manage the fluctuations and now we must discuss what triggers these movements:
1. Interest rates
We often discuss interest rates in our morning update due to the significant impact they can have on exchange rates. Even the slightest rumour of a hike can shift an exchange rate because higher interest rates provide higher rates to lend, which in turn raises more money from credit for the economy. A stronger economy equals a stronger currency, subsequently causing the exchange rate to shift.
Let's take the past 2-3 weeks as a great example: the Pound rallied following hints that a hike was imminent in early May. Conversations progressed, and the hike was almost confirmed but then the rug was pulled as the Bank of England's Mark Carney, suggested it wasn't definite. This then caused the Pound to tumble as confident was lost.
2. Inflation figures
Inflation figures provide an insight into the economic status of a particular country and have a direct impact on its currency. The currency relies on opposing aspects to the consumer.
High inflation for the public means the real cost of living is higher, whilst generally growing or higher inflation is perceived to be better for a currency. Most central banks will have an inflation target of 2% with a 1% tolerance either side. With a number of tools available to try and achieve the targeted rate of inflation; the most recognisable being interest rates. Interest rates are hiked to reduce inflation and loosened to stimulate growth.
Market perception can count for much of the unexpected movements. Referring back to interest rates, earlier this year, the Federal Reserve suggested they were on the road to another near-term rate hike. In stark contrast to when the Bank of England suggested the same, we saw the Dollar fall significantly. This relies on the market's perception of the topic, which remained uncertain in this case.
From market perception comes trading. If a currency trader or fund manager sees news which could impact a currency they are invested in, they will likely short their position and then sell the currency. You would see this on days when big data releases are expected or within a few minutes of an unexpected update. There'd be an initial drop, followed by a more intense drop as traders short their positions. On the flip side, this can also be said for buying, which causes mass rallies - after traders flock to a currency that's posted strong figures.
5. News and politics
It is not only hedge funds and inflation that causes movements in currency. Aside from the Euro, nearly all currencies are connected to a single country and any country-related news will ultimately impact its value.
For a currency, the most damaging attribute is instability and uncertainty. An example of this was Brexit's role in the Pound's recent demise. For the most part, we haven't and still don't know what Brexit will look like. Trade tariffs, passporting and boarders, for example, are still undecided. So, each time there's an inkling of clarity, the Pound gains significantly. In contrast, when faced with further setbacks or issues such as the Irish border, the Pound weakens.
We expect to see continued gains for the Pound, which will likely follow the overhanging issues. Even if the outcomes are worse than initially anticipated, the fact progress has been made will strengthen the Pound.
If you are regularly sending money overseas, it's good to understand how currency rates move. Alternatively, as there are many factors to understanding these movements clearly, we cover all the points above in our morning market update, which will help provide a daily analysis on the overseas currency market.
To find out more about fixing rates and avoiding any market fluctuations, read our related Managing currency rates during market fluctuation blog.