Understanding currency markets and exchange rates.

Aug 24, 2020

Welcome to Finance and Fury. I’ve seen news about the AUD being at a 15-month high

1. Today – wanted to do an episode on exchange rates and look at some of the fundamental driving factors in the price movements – next week put this together and look at the current trend and factors behind it
2. In the modern financial world – most exchanges are floating exchange rates (excluding some nations – like china that have a semi pegged currency to the USD – or others that just use it outright)
   1. What are floating exchange rates - A floating exchange rate refers to a currency where the price is determined by supply and demand factors relative to other currencies
   2. These are traded on foreign exchange markets – or called forex for short - allow for 24/7 trading in currency pairs – actually the world's largest and most liquid asset market
   3. But it is the largest traded market in the world – only a relatively small number of currency pairs are responsible for the majority of volume and activity – essentially 20 –
   4. As of 2019 numbers with countries ranked in volume – US no 1 with 44%, EU no 2 with 16%, Yen – 8.5%, Pound with 6.5%, AUD number 5 with 3.5% - top 5 close to 80%
3. In this market - Currencies are traded against one another as pairs – for example – when people talk about the AUD being at its 15 month high - against what? Well the reserve currency -USD – but what about other currencies
   1. Can have the USD/EUR, YEN/Frank - each pair is typically quoted in what is called pips (percentage in points) out to four decimal places
   2. While AUS to USD has gone to its 15 month high - return over the past 12 months has been 6% - against other currencies we are at a lower point – example – compared to the pound – down by about 0.71% over 12 months – Euro – about the same – 0.12% up over 12 months
   3. What does this say? Is it that the AUD is becoming more in demand, or the USD less –
   4. That is where it gets more complicated – as the movement of these pares is relevant to the factors that affect the price of each currency

 

How are the prices of these cross pairs affected – supply and demand of each currency

1. The AUD might have more supply, or less demand compared to the USD – so the cross-currency pair gets pushed down in price
2. Or when the world demands more US dollars - the value of the dollar increases and when there are too many dollars circulating without the demand to soak it up - the price drops
3. It sounds relatively simple -

 

But What affects supply and demand – A whole range of factors - Currency prices can fluctuate based on the economic situation of each individual country involved in the pair – including things like geopolitical risk and instability, trade & financial flows, among other factors –

 

These are some major indicators of the state of supply and demand that can be looked at -

1. Balance of payments – flows of foreign exchange –
   1. The balance of payments is a country's record of currency transactions across national borders – essentially payment data that comes out on a monthly or quarterly basis by a country's central bank
   2. The data is customarily divided into two main components: the current account, and the capital and financial account
   3. Current account – The current account balance measures the commercial transactions of goods and services
      1. It also includes any net foreign investment earnings and net international transfers of cash
      2. It is a representation of a national foreign trade balance showing total imports and exports- which is the net exchange of cross-border services

• Can include any import/export market – goods purchased, travel & tourism, payments for international shipments and transportation

1. in a general - the flow of foreign trade is considered a key component of the current account balance - a country that is importing more than it exports from month-to-month will have a widening deficit on their current account
2. The trend toward a current account deficit is considered an indication that foreign money is flowing out of a country and that a currency will likely weaken over time
3. So if a country is a major importer from another nation – with everything else being equal (supply of money and no other trade partners) – then their currency will likely decline

1. Capital Account – which is the other major component of the balance of payments
   1. basically a register of investments flowing in and out of a country - include direct investments and portfolio investments
   2. Direct investments - investments made in physical capital – can be real estate and property – natural resources - production facilities like factories, and machines and equipment

• Portfolio investment - investment in financial assets - like shares and government or corporate debt

1. falls into categories of short- and long-term investment – referred to as "hot-money"
2. This can increase the volatility of a currency – especially liquid investments like shares – imagine if the majority of the balance of payments was in shares – then foreign investors dump these shares – that is a lot of AUD converted back to other currencies and the demand for AUD drops -

1. For both of these and why it affects demand – if you are going to be buying goods or services in AUD – you need to exchange your currency for AUD – similar to buying property or shares here – therefore you need to exchange your currency for AUD to make the purchase – which results in an increased demand for AUD
   1. Think about this in reverse – say you wanted to buy Apple or Amazon shares directly – you would need USD to buy these – so on an online exchange your AUD would be converted into USD – this would count towards the Capital account of the US
2. These are all mostly on the demand side – sentiment and the amount of demand of currency changing hands

2. Foreign reserves - balance of foreign money that has accumulated within a country because of goods and services transactions – is a good measure of if a countries currency is in demand or not
   1. If there is a large accumulated balance in foreign reserve - there is a positive sum of the current account and capital account balances
      1. These reserves can then be invested in bonds or other assets – such as with China – accumulated $3trn USD in reserves over the years – and turns around and uses this to buy US bonds –
      2. However – an accumulating reserve means you are normally receiving incoming foreign money – hence your currency will likely be on a strengthening trend – like china – but they can use this balance of reserves to defend against volatility and speculative attacks against their currencies by selling portions of the reserves – and help them to maintain their peg

 

Other major factors – these are more of economic indicators – which affect the demand and supply of a currency

1. Inflation - is technically defined as an increase in the price of goods and services in an economy- however a high domestic inflation is generally considered to be a factor that prompts a weakening of currency over time against its peers - because of the economic principle of purchasing power parity is declining – so once you make for adjustments in an exchange rate – the real value of your currency relative to its international purchasing power of a currency is declining -
   1. Therefore - currencies in countries with higher than its peers inflation rates are considered to be good candidates to depreciate - Inflation in most developed economies that are considered "stable" is generally between 1 and 3% - however the exchange rates for currencies with much higher inflation will likely depreciate heavily
2. Interest rates –this can be an indicator that influences currency trends –
   1. First – can affect the capital account – either increases or reduces the demand for investing in other nations capital markets -such as government and corporate debt securities – where the returns are determined by interest rates
   2. So if a central banks was to raise interest rates – they are likely going to be attracting incoming foreign money from investors who are seeking higher returns – this puts upwards pressure on the local currency
   3. The reverse is also true - when central banks lower interest rates, money may flow out of their economies and currencies may undergo weakening
   4. International fisher effect -
      1. Think about AUD to USD back between 2011 and 2013 – in 2011 was almost 5% - by 2013 – dropped to 3% - since then has kept declining – But in 2011 – to 2016 it was 0.25% in US – hence there was a higher demand for AUD
   5. Also – interest rate policy affects the supply of a currency – by the nature of central bank policies – OMO and even now QE – the amount of money introduced into the financial system and economy to keep rates low increases the supply of a currency – if it is tied up – not a problem – but if it is in either trade (current account) – or in investments (capital account) – and flows out of the country – can put a downwards pressure on the local currency
3. Economic Activity - GDP Growth – the metrics that reflect an individual economy and the output – which is ultimately determined by the productivity of a country's private sector
   1. Looking at the GDP growth – can see an indicator of the level of economic activity in an economy – if the economy is growing – can attract investment and is a potential sign of currency strength
   2. But there isn’t much correlation here – can a weak currency can help to promote investment or exports as it is now cheaper -

 

This is just a few of the major factors – But when you add them all up – you can get an idea about likely trends –

1. but there is no magic number working really forecasting a currency trend
2. Can take the weight of all these factors together to show a path
3. Hence why this data mentioned is constantly under review by analysts who trade these markets – and these large financial institutions do have the capacity to influence trends
   1. As they affect demand through buying or selling a particular currency
4. Currency conditions and the demand/supply factors can change quickly – currency is very volatile – it is open 24/7 and the
5. Other intangible factors – like currency wars – that is where this is outside of any pure economic indicator

 

Summary - There are a number of factors that go into analysis of the fundamental health of economies and the implications for currency movements – and in turn these can affect the exchange rates –

1. Indicators like the balance of payments (capital and current accounts) and the level of foreign reserves a country has – including economic indicators like inflation, interest rates, GPD – all go towards affecting the exchange rate movements – but these are only at a cross currency level when looking at say the AUD to USD

 

Next episode on Monday – look at some numbers and factors that are in play with the AUD at the moment.

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