What Moves Exchange Rates?
By: Tim Bennett
22.6.2017
The Election result and Brexit are being blamed for the weak Pound. So in this short video I look at the other big forces that determine a currency’s value.
The direction of travel for the pound recently is pretty clear from the chart below. What this reveals is that Sterling has been falling for some time now against both the US Dollar and the Euro. Indeed its relative demise can be traced right back to 2015. So, whilst the chart can be, in part, explained by the uncertainty surrounding the political situation and our forthcoming Brexit, this week I take a look at the other, deeper forces that underpin currency movements. However, first of all, a quick bit of revision.

What is an exchange rate?

Exchange rates represent the price of one currency against another. As such they are always quoted in pairs. There are two types of rate – one for a deal now (“spot”) and the other for a deal at a future date but at a rate agreed now (“forward”). Below is a simple spot example. So the question is, what could cause the pound to “weaken”, such that it buys fewer dollars, or “strengthen” such that it buys more? One important answer is interest rates.

Interest rates

International investors want to make money on their currency deposits, so it follows that currencies that offer higher rates of interest will be more popular than those that don’t. This is likely to change their relative prices (the exchange rate).

For example, recently the US Federal Reserve has been raising rates from a low base and now has them in a range of 1% to 1.25%. In the UK on the other hand, the Bank of England cut its rate from 0.5% to 0.25% after the Referendum result in 2016 and it has stayed there since. Naturally this has weakened the pound against the dollar as the earlier chart clearly shows. Decisions about whether to create additional electronic liquidity (“QE”, which will weaken a currency) or do the reverse and remove it from the system (“QT”, which would tend to strengthen a currency) also play their part in determining exchange rates. But, whilst crucial, interest rates and any associated monetary stimulus are not the whole picture.

Current account balance

As a nation, the UK trades with other nations all over the world. We tend to import more than we export, which is fine but means we often need to borrow to finance the difference. This in turn creates demand for overseas currencies here, which tends to strengthen them and weaken sterling. This is summarised here;

Public spending and debt

A government may try to stimulate growth via public spending programs – we have seen hints of this in the US. The aim is to create demand and jobs, however the side effect can be inflation. The impact of increased government borrowing needed to pay for infrastructure depends on how the market views the ability of a government to service and pay off debt in the future. This is where credit ratings are important – the fact that the UK recently saw its rating reduced by one of the biggest agencies, Moody’s, is indicative of some nervousness on the part of investors.

Confidence

Currencies such as sterling act as a bellwether for the overall economic prospects of the UK – after all, the currency markets are the biggest and most heavily traded in the world. The Brexit vote and the recent close Election result have undoubtedly served to weaken sterling and will in all likelihood continue to do so while negotiations proceed. However, bear in mind that, as the earlier chart shows, Sterling has been weakening for some time and investors would be wise to fully understand the other reasons for this to get the full picture.


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