Have you ever faced the necessity of exchanging currencies and wanted to pick the right moment? It’s very hard to predict when and how rates will change. It’s important then to know about the factors that have the greatest impact on them. Although the knowledge won’t guarantee profits, it could help to avoid making potential mistakes – writes Bartosz Grejner, Cinkciarz.pl Currency Analyst.
The zloty gained against the dollar as much as 12% in seven months and 21% against the pound since December 2015. Those examples show that exchange rate changes tend to be quite significant. The value of one currency is usually expressed against another, so it’s important to know, for one, what’s the inflation (price growth) in both countries and what are the trends. A higher inflation in one country in relation to the other could cause its currency to be relatively weaker (taking into account only the impact of inflation).
Inflation isn’t always bad
It should be noted that inflation itself doesn’t need to be detrimental, if it’s on a stable and predictable path. It doesn’t have to be caused by internal factors only – external aspects strongly influence currencies as well. One of such factors could be the price of energy commodities, especially oil. These prices tend to be quite volatile similarly to the prices of food. Hence, in order to get to know the underlying inflation trend, a core index of inflation needs to be distinguished, one that is devoid of those most volatile prices.
It has been widely accepted that inflation of approx. 2% (+/-1 pp) is healthy for the economy, allowing the economy to expand near its potential growth. Recently, however, a lot of advanced economies have struggled with a contradictory problem – deflation, which occurs when prices decrease. It negatively impacts the country’s economic expansion slowing down the GDP (gross domestic product) growth rate which weakens the currency as a result.
Central banks dictate the terms
In order to avoid the negative impact of either inflation or deflation, central banks in each country (or region – as in the euro area) adapt interest rates accordingly. Their greater level in one country, in relation to the other, could mean that the yields in this country are relatively higher.
This encourages investors to place their capital in a country with higher interest rates. As a result, there’s a higher demand for this country’s currency. The fundamentals of economics tell us that a higher demand equals a higher price, so the currency in such a scenario will appreciate – that is, increase its value. However, interest rates that are set too high could also be detrimental to the economy.
The cost of credit will then be higher, limiting consumption and investments. The inflation could also be dampened and fall below the target level, which could hamper the growth rate of the economy. Several of the world economies have been dealing with such a problem recently. The US financial crisis in 2007/2008 caused the central bank (Federal Reserve) to decrease the main interest rate to zero and start a bond purchase program, which in effect meant “pumping in” dollars in order to stimulate both the economy and inflation. Currently, this program has been closed and the interest rate has already been hiked twice.
Negative interest rates were introduced by the Bank of Japan and the European Central Bank, which is responsible for the eurozone. The latter reacted to a credit crunch in the euro area, which brought about deflation and a slump in economic growth. Positive effects, in the form of higher inflation and GDP growth rate, have already been gradually observed. However, the negative interest rates and the asset purchase program (approx. 60 billion euros monthly), have sent the euro’s value lower. Negative rates will probably be maintained throughout the whole of 2017.
What is the effect of such an accommodative policy? More euros in the market and higher supply exerting negative pressure on its value. Hence, one could expect that the euro potential appreciation against the zloty is limited because interest rates in Poland remain on a higher level (1.5%).
Expectations also play a key role
The value of a currency is also determined by its future value expectations. Analysts and economists base their forecasts on economic and political aspects, including predictions regarding future interest rates and inflation levels, among others. In the short term, it’s the expectations that are responsible for most of the exchange rates fluctuations.
The dollar’s value fluctuation after the US presidential elections is an example from the last few months. When Donald Trump was elected, investors had high hopes for increased spending on infrastructure or the simplification of the financial system. Even before the new president had been sworn in, not to mention started to make any decisions, the dollar reached 13-year highs against the euro and 15-year highs against the Polish currency (zloty).
A similar example could be seen in the euro area. The European Central Bank has been maintaining a very accommodative monetary policy including maintaining a negative interest rate, which will most probably not be changed until the end of 2017. This in itself has decreased the euro’s value, however, low inflation expectations for the current and next year (below ECB’s 2% target) has justified market predictions that the ECB won’t tighten the monetary policy because there will be no adequate condition for such a scenario. It has ultimately caused the demand for the euro to be lower and its appreciation potential to be limited.
Knowledge helps when risk is tempting
Are those the only factors influencing currencies? The answer is: of course not. Trade balance, the difference between exports and imports, is of great importance as well. A potential surplus could cause a higher demand for the currency – foreign entities (both consumers and businesses) buy more goods in that country. Hence, the need to exchange currencies generates demand for it causing it to gain value. Public debt is no less important – the greater it is, the higher investors’ uncertainty that the country can actually pay it off.
This could bring about a sell-off of the country’s assets, including its currency whose value could ultimately drop. Public debt is also connected with a country’s rating, set by rating agencies. That gives investors some measure of assessing how risky a country’s debt could be, or how high a premium for the risk they should demand. This also translates to the value of the currency, which also reflects the country’s specific risk.
There are many more factors that influence a currency, although the individual impact could be less substantial. The factors that currently dictate the value of a currency could change at any given time, especially in the short term. That’s why it’s essential to analyze not only the two countries, which currencies one wants to exchange, but also the state of the biggest economies in the world as their condition and current developments could impact all markets.
We have to remember that understanding which factors play the most important role in determining currencies’ values won’t guarantee an exchange at the most favourable rate. Taking into account recent market developments and currency fluctuations, however, suggests that knowledge of such elements could greatly help in picking the optimal time and strategy to swap currencies, limiting the risk of substantial loss at the same time.