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Which factors dictate currency values?

International businesses and individuals with global interests are impacted by fluctuating currency markets. Monthly volatility often exceeds several percent, which can be enough to wipe away profit margins and drastically alter cash flow.


Many of our clients don’t have the time to monitor global events, track intraday movements and study the complex factors, so they turn to us to keep them abreast of political and economic developments.


There are various reasons for increases and declines in relative currency values, the most prominent of which we’ve summarised below, many of which are intrinsically linked:




Inflation Differential


Inflation is a term used to describe the increase in the average price of a region's goods and services over a period of time. For example, if UK inflation rises, each pound buys fewer apples, hence the value of that pound has depreciated. The exchange rate will be affected because of supply and demand. For instance, if the price of goods and services rises faster in the UK than in the US, Americans have less interest in buying the pound because it buys less goods and services, so the pound's relative value declines.


The Central Bank is largely responsible for controlling inflation using monetary policy to guide/build a healthy and sustainable economy.



Central Bank Monetary Policy


Interest rate differential - 


Consumers pay interest in order to borrow money and receive interest when lending banks their own. A country’s Central Bank generally sets a ‘base rate’ several times per year, which influences interest rates throughout the economy. A Central Bank will raise its interest rate in times of economic prosperity (monetary tightening), in order to make borrowing more expensive, which encourages people to save, rather than spend. The nation’s currency generally strengthens in this instance because demand increases when the interest rates are raised, as foreign investors are attracted by the higher yield. ‘Hot money’ inflows end up in countries that offer high rates of interest. Interest rate adjustments are one of the most important and transparent events and traders are constantly monitoring rhetoric from policy setters during press conferences to determine the most likely course of action.


Loosening the money supply -


When the money supply is expanded or easily accessible it’s referred to as ‘loose’. Sometimes a Central Bank will create/print more currency which is injected into the banking system, which should filter through to the rest of the economy. In line with the basic principles of supply and demand, if there is more currency in the system, each unit loses value and the price weakens.



Foreign Exchange Market Intervention


A monetary authority such as a central bank may intervene if its national currency becomes too strong, to prevent adverse effects on the economy. Intervention can be split into four categories but the two methods that have the highest impact on the exchange rate are as follows:


Jawboning: A verbal technique and the simplest form of intervention. The chief of the central bank may 'talk down' the economy and insinuate its future policy intentions during a press conference/statement, with a view to influencing the market, triggering a sell-off reaction from market participants.


Operational: The most common form of physical intervention, predominantly occurring when a central bank sells vast quantities of its national currency for another (often by exchanging bonds), in order to weaken its relative value. A larger supply in comparison with demand pushes the price down.


A good example of when a central bank might intervene in the foreign exchange market is in Switzerland with the Swiss National Bank (SNB). The Franc (CHF) is widely considered a haven currency around the globe due to the stability of the country’s national policies and strong economy. During times of global risk and uncertainty, investors typically pile into the currency for shelter. However, this isn’t always good for the local economy which relies heavily on global exports – a stronger currency makes products dearer on the international stage and thus less competitive. If the CHF appreciates to a point whereby the SNB deem it is having a negative impact on the Swiss economy, it might act in one of the aforementioned ways.



Balance of Payments (BOP) – Current Account Deficit/Surplus 


The ‘balance of payments’ is the measurement of total transactional volumes, including imports and exports of goods, services and capital and money remittance. If a country takes in more money than it sends out, for instance if revenues from exports rise drastically and exceed the price of imports, demand for the currency will have increased, which can cause its price to rise in comparison with its trading partners. 



Government/National Debt


This is the amount of money a government borrows to finance its expenditure. Governments typically sell bonds or other securities in order to raise capital. If a country’s borrowing increases to a level that may be difficult to manage without a credible strategy to repay it, it could be considered fiscally irresponsible and in extreme cases can cause them to default on their loans. Therefore, it is likely to prompt investors to sell their assets in that currency and flee to a safer asset class, resulting in a currency depreciation as demand drops.

If a major financial analysis agency such as Moody’s downgrades a country’s credit rating, it’s an indicator of default risk, so the currency will often devalue for the reasons explained above.



Speculation


Some investors purchase currency because they believe it will increase in value and they can sell it for a profit. During periods where there is a higher demand for a currency, the price will rise and vice-versa.



Economic Performance/Macroeconomic Data & Politics


Foreign investors often plant their capital in stable countries with a strong economy and turn away from nations with high political uncertainty/turmoil and economic risk. A higher demand for the currency causes the price to rise. This can be referred to as 'flight to safe havens'.