How it Works: Your Guide to the Currency Market
Posted by Adam Solomon on March 12th, 2018.
Many news outlets report on currencies strengthening or weakening due to some factor or other. We’re told that Sterling has rocketed, or the Dollar has slumped, or the South African Rand is holding its ground, but it isn’t always clear whether this is good news or bad news.
Currency news articles also tend to talk about things like interest rates, inflation and monetary policy tightening outlooks. They might say that hawks are talking like doves or that bears have turned into bulls.
The question has to be asked: what on earth are they talking about?
If you find the whole thing a little bit baffling, here’s the TorFX quick guide to understanding currency markets news…
Exchange Rates
Exchange rates are simply the market value of one currency compared to another. So, for example, 1 Pound may be worth 1.4 Dollars. That means, in theory, the shiny Pound coin in your pocket would buy you 1 US Dollar and 40 cents.
Exchange rates are expressed as a ratio between two currencies (known as a pairing). Each currency is assigned a three-letter code, known as its ISO code. So, for example, the Pound (GBP) to South African Rand (ZAR) exchange rate would be expressed as GBP/ZAR.
Exchange rates change on constantly, with the value of one currency relative to another changing in reaction to a host of factors – not all of them economic – including political stability, conflict, social issues and even the weather.
If an exchange rate is ‘strong’ it means that is has risen in comparison to recent or historic levels. Making a currency transfer at a stronger exchange rate means you’ll be able to buy more of the currency you want with the currency you have than you would have when the exchange rate was weaker.
If, for example, the GBP/EUR exchange rate rose from €1.12 to €1.16, a currency transfer of £100,000 would be worth €112,000 at the lower exchange rate but €116,000 at the higher one – a difference of €4000.
There are many reasons why a currency might strengthen against other currencies.
Let’s look at some of the main causes of exchange rate movement…
Central Banks
These governing financial institutions are the money-creating banks that commercial banks borrow from. Usually they’re controlled by the national government and have the power to set interest rates, create credit, set fiscal (tax) policy and do other things which impact the economy.
The policy decisions made by central banks can have a significant impact on the currency markets.
In terms of foreign exchange (Forex) news, the central banks you tend to hear a lot about are the Federal Reserve (US), the Bank of England (UK), the European Central Bank or ECB (Eurozone) and the Reserve Bank of Australia (Australia).
Interest Rates
Put simply, interest rates are the cost of borrowing, set by a country’s central bank. In reaction to the 2008 global financial crisis, interest rates across the industrialised were cut close to zero (or in some cases, below zero). This was done to encourage borrowing and stoke economic growth.
The reason interest rates are so important to Forex traders is that they naturally want to park their money in countries where it will earn interest – and it makes sense to park it somewhere it will earn the best rate of interest. Subsequently, signs that a country is about to raise its interest rates can cause an inflow of money from the currency markets, while indications that interest rates are about to be cut have the opposite effect.
Quantitative Easing
Quantitative Easing (or QE), is the means by which central banks can stimulate the economy by purchasing financial assets, such as government and corporate bonds, in order to boost demand within an economy. In conjunction with low interest rates, QE has been the other main monetary policy ‘carrot’ of central banks over the last 10 years.
A policy of low interest rates and high levels of QE is known as a ‘loose’ monetary policy. Conversely, as interest rates rise and QE programmes are wound down (or ‘tapered’) monetary policy is said to be ‘tightening’.
Forex traders look for signs of QE programmes ending, as that can be an indication that interest rates will soon rise.
Inflation
Inflation, strictly speaking, is an expression of price rises across an economy. Central banks have a target inflation rate for their country that they try to achieve through monetary policy. If inflation gets too high and outpaces wage growth it will damage the economy as consumers become unable to pay for goods and services. Central banks then try to ‘damp down’ inflation by raising interest rates.
On the other hand, if inflation is low or negative (known as deflation), central banks will try and stimulate the economy, often by cutting interest rates.
Foreign exchange traders consequently keep a close eye on inflation as this gives an indication of central banks’ likelihood of increasing or lowering interest rates.
Speculative Trading
Back in ancient Egypt, foreign exchange was a pretty straightforward affair. If you wanted to trade some bushels of wheat with someone in a neighbouring city, you’d agree on a price with them and make the exchange using coins that were backed up by some form of precious metal, usually gold. Fast forward five thousand or so years and we have a globally interconnected foreign exchange system that handles some $5.3 trillion a day.
That’s a lot of money and, as you’d expect, not much of it is used to buy and sell bushels of wheat. Today’s Forex market is unregulated, with money free (more or less) to move anywhere around the world. There are no clearing houses or arbitration panels, so perhaps unsurprisingly it attracts speculative investors.
Speculative investors have one aim: to make money by trading. Because of this, the vast majority of money whizzing around the world between foreign exchanges is speculative in nature.
Fiat Currencies
Originally, all currency was backed by something of value – usually a precious metal. Sterling was, at one point, backed by silver – with the word ‘sterling’ thought to date back to the Old English ‘steorling’, meaning ‘little star’ – and to that end all Norman pennies were imprinted with a small star. Many other countries were backed by gold – a system known as the Gold Standard.
In this way, a country’s currency was directly indexed to how much physical gold resided in their national coffers, and this system persisted until the Great Depression, when countries including Great Britain were forced to abandon it following speculative attacks. In 1971, President Nixon took the US off the Gold Standard.
Instead of being backed by precious metals, currencies around the world instead became known as fiat currencies. The word ‘Fiat’ means ‘let it be done’ in Latin, and in practice this means the value of a currency is held simply in the fact that the issuing government says it has value.
The effect that fiat currency has had on the foreign exchange markets has been dramatic, it effectively means that the value of a currency could be zero, or at the other end of the scale, a single unit of it could be worth a fortune!
Commodity Currencies
Some countries have a lot of natural resources and raw materials that they sell on international markets. In fact, they have so much of the stuff that any change in price for the commodity they are selling can have a pronounced effect on the value of their currency.
Examples of this include dairy products in New Zealand, iron ore in Australia and crude oil in Canada. Currencies from these nations are generally considered to be ‘risky’ currencies as their value is correlated, to an extent, by the price of the commodities they’re linked to.
Example: Australia exports iron ore, coal and various minerals to China. If the price of iron ore fell dramatically, Australia’s economy would suffer, making the Australian Dollar less attractive. To offset this risk, central banks in countries that rely on commodities tend to set their interest rates relatively high. These are then known as ‘high-yield’ currencies.
Reserve Currency
The US Dollar is the world’s premier reserve currency at present. A reserve currency is a kind of monetary lingua franca and can be used all over the world, even between two countries that have no connection to the US. That’s why most commodities – especially oil – are quoted and traded in USD (hence the term ‘petrodollar’).
Hawks, Doves, Bulls and Bears – Oh My!
Quite simply, think of hawks and bulls as being active and aggressive, and doves and bears as being passive and cautious. Thus, a trader, politician or central banker being ‘hawkish’ indicates that he or she is talking up the market because they are anticipating (or trying to cause) some form of robust movement. The clarion call of the hawk or bull is “Let’s do it!”
Doves, on the other hand, err on the side of caution. They think market conditions are getting weaker, or that the situation is more likely to deteriorate than improve. Their clarion coo might be “Let’s just wait and see.”
A market tearing ahead and showing above-curve growth is said to be a bull market, whereas one that is sinking or anaemic and driven by cautious risk-averse traders is said to be a bear market.
Currency traders generally favour bull markets as more money can be made in them, which is why any ‘bullish’ or ‘hawkish’ comments made by policymakers get them excited.
Currency Brokers
A currency broker is a specialist company who buys and sells foreign currency on behalf of private or corporate clients. Typically they can offer their customers a much better deal than banks and provide a much more personalised level of service.
What’s more, a good currency broker will know the Forex market inside out and will be able to provide expert guidance about current and future exchange rate movements.
This has only been a basic introduction to the complicated world of currency exchange, but if you’d like to find out more about how exchange rates work or how the latest news could impact your currency transfers, please get in touch!
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