What affects currency trading?
By Steve Fox, head of treasury, Fairbairn Private Bank
In our increasingly globalised economy, one’s travel, employment
and business commitments can often evolve into assignments or
contracts around the world, potentially leading to foreign
investment opportunities, overseas property purchase, overseas
educational or other family needs.
Fortunately, the increased accessibility of international
financial markets now means that individuals can regularly transact
in currencies other than their domestic currency.
In 2008, the pound experienced one of the steepest declines on
record. However, critics believe that it was weak to begin
with, and spent much of the past decade overvalued. So what does
determine a currency's exchange rate, and why are currencies
sometimes deemed to be over or undervalued?
The UK entered a recession mid-way through 2008 and as a result
of this we have seen UK interest rates fall to an all time low –
making the UK a less attractive place to invest. Sterling
based investors who chose to invest in other countries, such as
South Africa, have boosted their assets over this period because
the fall in sterling has increased the rand value of their
investments. If UK interest rates go down, or more importantly, are
expected to go down, the value of the pound will tend to weaken
against other currencies, and vice versa.
Economic growth, as measured by gross domestic product and
employment levels, generally paints a picture of how robust a
country’s economy is. Increasing productivity in an economy
can positively influence the value of its currency. The better
the currency performs, the more demand for it there will be.
Foreign currencies are specifically dependent on their own
country’s imports and exports. Other countries must buy
sterling in order to buy UK goods, so if there is a high demand for
British exports (relative to our demand for foreign imports), the
pound will tend to strengthen. However, conversion rates can affect
the level of imports versus exports in a different way, for
example, if the pound is strong, UK exports become less attractive
and foreign imports more so.
A country’s currency is greatly affected by its political
situation. Elections, social upheaval, new political power and
civil war can cause an economic downturn, which, in turn, will
reflect on its currency. For example, an unstable government
in Iraq has had a negative effect on the dinar. In times of
political instability, traders will be reluctant to invest into
assets denominated in an affected country’s currency. They
will want to invest in perceived ‘safe havens’ such as the US
dollar, Swiss franc and gold, which are considered ‘safe’ at times
of political unrest. Investors will not want to take
unnecessary risks.
Central banks or governments can sometimes influence the
relative value of their domestic currency through monetary, fiscal
or wholesale foreign exchange market actions. These strategies
can adjust the currency price, but the size and volume of the
wholesale currency markets makes it impossible for one entity to
drive the market for a length of time. Looking at one currency
pair is not enough to gauge a currencies overall relative strength
or weakness as each currency moves against other currencies as a
result of supply and demand.
Foreign exchange rates can react quickly to many different
factors or surprises due to the extremely liquid nature of the
24-hour foreign exchange markets. Currencies are also traded as
speculative investments and experts trade them according to how
they think the market will move. These trades in themselves will,
of course, affect exchange rates.
Currency speculation can be tempting, particularly with the
current volatility in financial markets, however, trading currency
involves serious risks. If a client wishes to speculate, it is
vital they have a sound understanding of why currencies behave in
the way they do. Currency movements cannot be reliably forecast as
they are influenced by such a wide range of macro-economic and
geopolitical issues. Foreign exchange risk is directly related to
the volatility of currencies and this can affect the value of a
client’s assets and liabilities accordingly.
Speculation aside, managing exposure to foreign exchange
fluctuations and mitigating foreign exchange risk are still key
issues for the increasing number of clients operating
internationally. The foreign exchange services offered by
Fairbairn Private Bank can be used to support investment decisions
in any of the world's major currencies and with the multi-currency
banking options generally available even the requirements of the
most complex portfolio should be supported.