Unless you’ve been living under a rock for the last 12 months, you’ll have noticed something strange going on with many of the world’s biggest currencies in 2016, with the terms ‘all-time high’ and ‘all-time low’ dominating the financial news. Take sterling for example: it fell 28.4% against the Brazilian real and 14.39% against the euro, but gained 105.8% against the Egyptian pound.
We all know that exchange rates can fluctuate from one moment to the next – after all, it’s the comparison of two different currencies – but the reasons behind the maths are harder to grasp. So we’ve delved into the world of financial trading to get the answers.
At the root of all this fluctuation is the basic principle of supply and demand. A currency is just like a mango or an iPhone 7: if it’s in high demand (which often goes hand-in-hand with being in short supply), it will cost more. So far, so straightforward. But what actually causes this demand to rise and fall? This is where many different factors can come into play – from government actions to consumer confidence and political upheaval.
Setting the rates
Money supply and interest rates are two of the major factors that affect demand for a currency. Both can be controlled by governments and their central banks, which use them as tools to manipulate their economies. In the UK, the Bank of England sets the official interest rate, known as the Bank Rate, which in turn influences high-street borrowing and lending rates. This is currently 0.25%, but it’s not always so low – in November 1979 it reached a peak of 17%.
The money supply means just what it says – it’s the total amount of money that’s in circulation in a country. If there’s a higher amount of a currency floating around, the value of that currency will decrease against other currencies and the exchange rate will dip. High money supply is also linked to low interest rates (again, because a larger supply means lower demand).
Lower interest rates, in turn, also tend to lower the value of a currency – because investors get low returns on investments in that currency. This may make low interest rates seem like bad news. But there’s another, longer-term angle that explains why governments may choose to lower interest rates: low rates mean that people borrow more and spend more, which should make the economy grow.
There’s yet another twist to watch out for, and that’s inflation. If inflation (the rate at which prices are rising) gets too high, because demand for goods exceeds supply, it can cause economic instability and a fall in the value of the currency. Put simply, people can’t afford to buy all the same things they used to, so businesses may struggle to sell products and services. A central bank may then attempt to counteract inflation by raising interest rates, thus encouraging people to save rather than spend it on goods. This means that demand drops and inflation slows down.
We’ve seen how low interest rates generally make for low exchange rates. But the converse is also often true: higher interest rates are generally associated with higher exchange rates because investors get a higher return on their assets compared to the same assets in another currency.
Related to all of the above is one overarching factor: stability. The market loves it and is constantly monitoring economic indicators and current events to find where it exists and where it may be lacking. A strong, stable economy – with consumer confidence reflected in a good degree of spending, low unemployment, a buoyant housing market and increasing gross domestic product (GDP) – encourages investment and increases demand for a nation’s currency.
However, if the country is going through a period of political upheaval, these economic factors pale into insignificance. Political unrest is often the harbinger of doom for a country’s economy. This discourages foreign investment and often leads to a decrease in demand for the currency and its value drops across the globe: for example, uncertainty over the repercussions of the Brexit vote led to a freefall in the value of sterling. So when it comes to maintaining the value of a currency in the long term, confidence and stability are the watchwords. And in the short term? As we said, it’s complicated!
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