It’s been a dramatic year for currencies all over the world. The Covid-19 lockdowns sent the foreign exchange market haywire, with the kind of political and economic volatility in Europe not seen since the Brexit vote in 2016.
There was significant euro currency fluctuation in March 2020, with huge gains for the euro against the British pound. Pound sterling then rallied and became the rising currency. But given that both the UK and the Eurozone experienced lockdowns, what caused all this currency change?
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.
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Why do foreign exchange rates fluctuate?
What makes a currency go up and down? Well, at the root of all this fluctuation is the basic principle of supply and demand.
In countries that have a floating exchange rate, a currency is just like a mango or an iPhone 11: 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.
How do interest rates affect currency fluctuation?
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 economy and their domestic currency.
In the UK, the Bank of England sets the official interest rate, known as the Bank of England base rate, which in turn influences the interest rate when you borrow money. The base rate is currently 0.1%, which is a historic 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 foreign 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 make a currency drop in value – 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.
How does inflation cause a currency fall?
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 currency depreciation.
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 put their money into a savings account 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.
How does market stability affect the exchange rate?
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!
We can’t promise that exchange rates won’t fluctuate, but we can promise you faster, cheaper money transfers and low, transparent fees. With Azimo you can save up to 75% versus banks and other providers. Even better, we’ll give you two fee-free transfers when you register with Azimo today.