What really forces currency markets and exchange rates to change?

Why do exchange rates fluctuate, often dramatically?

Ben Chu
Economics Editor
Monday 19 November 2018 11:06
What moves currency markets?

The pound’s up, the pound’s down. The dollar’s soaring, the dollar’s plummeting.

But why? What moves currency markets? Why do exchange rates fluctuate, often dramatically?

The answer is supply and demand. If demand for a currency goes up its price will rise. If demand falls, its price will tend to fall.

But what can determine supply and demand?

First, expectations of national economic weakness. Think of things like war, or a natural catastrophe, or some other radical change of circumstances with economic implications. A good example is the impact of the Brexit referendum on sterling. So what’s going on? Bad macroeconomic news implies lower economic activity and less inward investment from abroad due to lower returns. That makes investing money in a currency less attractive to external investors, so there’s less demand for a currency from abroad. The result? The exchange rate goes down.

Second, expectations of national economic strength. This works the other way. It can be sparked by unexpectedly good GDP figures. Perhaps a new oil or gas discovery. Sometimes it’s driven by political decisions. Think of US dollar currency’s response to Trump’s election victory, with him having promised tax cuts and an infrastructure spending splurge in the campaign. These were all expected to lift the growth rate, at least in the short term. Macroeconomic strength means interest rates likely to rise to head off domestic inflation. Rising domestic interest rates mean better returns which means more demand from abroad. The result? The exchange rate goes up.

But it’s important to remember that the value of a currency is a relative measure. A nation’s currency is always valued in a foreign currency. So sterling is measured in dollars or euros or yen or rand or the Mongoloian togrog, you name it. If the value of another country’s currency rises that means yours can fall, even if nothing has really changed about the economic outlook for your country. When the dollar rises against the pound it can be because the US economy is doing well. It doesn’t necessarily mean the outlook for the UK economy has got any worse

And a final word of caution. Don’t make the mistake of believing that currency moves are always based on rational and careful assessments by currency traders and investors of underlying economic conditions. In the short term – and possibly even the long term – there is a very large dose of knee-jerk sentiment, herding and, sometimes, blind panic involved.

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