Four factors that affect exchange rates

Why does sterling rise and fall?


Why does the pound rise and fall?

It hasn’t always. For more or less the whole of the 19th century and a good part of the 20th, £1 was worth about $5. But then, in 1940, following the effects of the First World War and the Depression on the markets, the exchange rate was fixed at $4.03 to the pound. It was devalued again in 1949 to fix the pound at $2.80 – more than twice as much as you get today.

This gradual decline reflects the long-run strengthening of the US economy compared to the UK’s – and the UK’s higher levels of price inflation over the long-term. It wasn’t until August 1971 that fixed exchange rates – the so-called “Bretton Woods” system in place since the mid-1940s – were abandoned as unrealistic. Since then, sterling has been a “floating” currency rather than a “fixed” one (notwithstanding its unhappy period inside the European Exchange Rate Mechanism [ERM] between 1990 and 1992).

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The pound’s value against other currencies now rises and falls in response to changes in demand on the currency exchanges and for sterling-denominated assets on global markets.

What drives changes in demand for sterling?

Ultimately, demand is driven by what the market, in its collective wisdom, thinks about the attractiveness of UK assets and the health of the UK economy. In broad terms, the strength of a national currency reflects the perceived strength of that country’s economy and its future prospects. If that perception changes, the currency moves – and sometimes that can be sudden, radical, and brutal.

The most obvious recent example of this is the plunge in sterling following the vote for Brexit in June 2016. Investors feared leaving the EU would mean a weaker UK economy and sterling ultimately lost 20% of its value, before recovering some of it. Such a dramatic plunge is the exception, however. Day to day, the rise and fall of sterling is dictated by a range of much more mundane economic factors and indicators, such as the current monetary policy, interest rates, inflation and the state of the UK trade balance and overall debt.

Why do these things affect the pound?

In general, a higher interest rate in the UK relative to other countries means investors should get a higher rate of return on UK assets, an expectation that attracts money into sterling and leads to an appreciation – a rise in its value. That said, policymakers don’t have magic powers to boost the pound at will.

Currency moves are not always predictable and can surprise at times; for example, when the Bank of England announced a 0.25% rise in its base rate at the beginning of this month – the first rise since 2007 – the pound actually fell because the market had already priced in the small rise. Investors instead focused on the Bank’s accompanying – and, to some, disappointing – warning that any subsequent rises were likely to be smaller and slower than many had been expecting, making sterling a bit less attractive.

Are there any other factors?

Alongside monetary policy, inflation is a very closely watched indicator for the currency markets. While economics is not an exact science, in general, countries with higher inflation rates will typically see their currencies depreciate in the long run. Investors also watch the balance of trade. If the UK persistently has a negative trade balance, where it imports more than it exports, the resulting demand for foreign currencies and excess of its own currency means the pound is likely to fall.

Finally, there is political uncertainty, which investors tend to think will breed economic weakness; renewed speculation over Theresa May’s position as prime minister earlier this month, for example, led to the pound to fall.Of course, a weaker currency is not always a bad thing. It can help exporters if, crucially, the lower prices mean they sell more of their goods. And famously, the devaluation that followed the UK’s exit from the ERM in 1992 proved a blessing because the overvaluation of the pound within the system damaged UK competitiveness.

Generally, however, it is folly for a country, especially a trading nation such as Britain, to welcome a sharp decline in its currency. After all, if devaluation were a recipe for economic success, the people of Venezuela and Zimbabwe would be celebrating – and rich.

If readers think sterling will strengthen/ weaken, what should they do to benefit from the rise/fall in the value of the Pound?

If you think sterling will appreciate or depreciate in value over time, you can use a Limit Order to potentially buy or sell at a better level than where the market currently sits. When the prescribed rate of exchange is reached in the market, the exchange will automatically be made for you, which could help you take advantage of market moves. Should you wish to protect the current level you are buying or selling sterling, you can use a Forward Contract to lock in the current rate of exchange, for delivery in the future. This can offer you peace of mind and an exchange rate that works for you and your longer-term currency strategy.

Are the Eurozone's problems now resolved - and will the currency now strengthen?

At the beginning of the year, experts and analysts alike were predicting the demise and potential failure of the euro. With the rise of populism and far right political candidates in the Netherlands, France and Germany, the world was set to watch the euro experience some rocky times, how wrong we were! Following the failure of Marine Le Pen to secure a victory in France, the Euro increased more than 12% this year. It’s not totally out of the woods. As we have seen recently with Angela Merkel’s coalition negotiation, political forces are becoming more polarized, which makes it difficult to find short term stability for the region. Brexit negotiations will also have an impact on the euro in the coming months, so be prepared for more volatility ahead.

Is the pound undervalued after the post-Brexit vote slump?

Since its post-Brexit vote slump, the pound has recouped more than 9% vs the dollar this year. The gains have come as a result of better than expected UK data and an unexpected change in stance from the Bank of England re: inflation, which led to an interest rate rise few had predicted a couple of months earlier. As well, a weakening dollar as Donald Trump over-promised and under-delivered. Indeed, U.K. data results could paint a rosy picture; unemployment at a record low of 4.3%, the aforementioned rate rise and significant increases in exports, manufacturing and output, driven primarily by the weak pound.

Arguably these results should reflect a much stronger position for the pound, however, in recent times we’ve seen the rising influence of geopolitical events impacting currency value. Thus, Brexit negotiations and leadership uncertainties continue to temper the pound’s value.

The pound could make considerable gains should progress be made re: Brexit negotiations and the settlement of the divorce-bill leads to an opening of trade deals at the EU leaders meeting in December. If you’re expecting to make an exchange to pounds, shortly, you might want to consider working with a currency specialist, like OFX, to take advantage of a forward contract to safeguard your ‘Brexit-discount’, now.

How will the Brexit negotiations affect exchange rates?

Brexit negotiations began in June, this year. As talks continue, we expect to see increased volatility for the Pound, Euro, Dollar and all other major currencies on the back of Brexit negotiations. The final impact on all major currencies will depend on who holds the strongest political leverage at the end, but, we shouldn’t forget other geo-political and economic factors will have a part to play in where exchange rates sit at this point.

We’ll be watching the tensions over North Korea, Angela Merkel’s next steps to remain Chancellor of Germany and the continuing leadership struggles in the U.K. Unlikely, but, still a possibility is a reversal of the Brexit vote, which should have a positive impact on the pound.

Has inflation peaked, and if so what does that mean for the pound?

Inflation is running above target for the U.K., putting pressure on the Bank of England. If price pressures continue to build, the probabilities of another rate rise by the Bank of England will increase, putting upward pressure on the pound.

Is the rise of Bitcoin anything more than a bubble?

Bitcoin, the most widely known and recognised of cryptocurrencies, recently saw highs of $8000. Although perhaps an overvaluation, and considered a bubble of Bitcoin, the days of Bitcoin itself, being described as a bubble, are over. It has proven critics wrong time and time again bouncing back from significant loses, the latest of which we saw in September, when the Chinese government intervened in cryptocurrency investments. But, Bitcoin is seen as an alternative investment, outside of the classic options. Bitcoin’s continued success and reputation as an alternative investment solution will depend on further developments on the technology and the reception from markets.

How might business owners be exposed to currency fluctuations without realising it?

Business owners could be exposed to currency fluctuations in a number of ways. If you work with international suppliers in any capacity, you’ll likely pay them in their currency. Dependent on how the arrangement works i.e. payment on order or delivery, etc. there will be a period of time in which you are exposed to currency fluctuations. At OFX, we advise our business clients to take advantage of forward contracts to lock-in a rate for delivery later. This gives you a stable currency level that you can use as an assumption to plan andbudget for the year, removing the potentially negative impact that currency fluctuations could have on costs.

Similarly, business owners expanding operations overseas could also feel the effects of currency volatility between planning and execution phases. If you are launching overseas, ensure you calculate your budgets using an average foreign exchange rate taken over a period of time and either build in a margin to account for currency fluctuations or speak to a currency specialist to build a currency strategy that’s right for yourbusiness.

For more information from OFX on currency fluctuations and other matters, please click here