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Why Do Exchange Rates Move?
Floating Exchange RatesIn a floating exchange-rate environment, the exchange-rate responds to many factors including the flow of imports and exports, the flow of capital and relative inflation rates. Often, limits are placed on exchange-rate fluctuations according to government policies.
One factor affecting the exchange-rate between the pound and other currencies is the merchandise trade balance. By definition, the merchandise trade balance is the net difference between the value of merchandise being exported and imported into a particular country. For example, consider the exchange-rate for GBP/USD. The UK imports products from the U.S. To pay for them, companies in the UK need US dollars; therefore, the UK companies trade pounds for US dollars. On the other hand, because Americans desire UK-made goods, they purchase pounds to pay for these goods. The net effect is an increase in the supply of US dollars and pounds. The UK's demand for American goods and services contributes to the demand for US dollars while American purchases of UK goods and services contribute to the demand for pounds. In this case, the net difference between the UK's purchases of American goods and services and American purchases of UK goods and services is the merchandise trade balance between the two countries.
The flow of funds between countries to pay for stocks and bonds purchases also contributes to the exchange-rate between currencies. In the near term, these capital flows are greatly influenced by yield differentials. All else being equal, the higher the yield on German securities compared to American securities, the more attractive German securities are relative to American securities. An increase in German yields would tend to raise the flow of U.S. dollars into German securities as well as decrease the outflow of Euros to American securities. Combined, this increased flow of funds into Germany would lower the value of the U.S. dollar and increase the value of the Euro. Therefore, the Euro to U.S. dollar ("EUR/USD") ratio, as it is represented in the FOREX market, would increase. Hence you would need more U.S. dollars to buy one Euro.
The rate of inflation is another factor influencing currency exchange-rates. Inflation occurs when the rate of money growth in an economy is higher than the rate of growth in real GDP. Hence more money is chasing fewer goods which in turn drive up the prices of these goods. Since exchange rates are an expression of one unit of a currency in terms of another, inflation essentially changes the relative value of this relation. For example, if America is experiencing higher inflation than the UK, then the GBP/USD ratio increases to represent the increased value of pounds relative to American dollars. Or seen in another way, one pound will now buy more American dollars. There are simply more American dollars around relative to the pounds. This fact is based on the concept of purchasing power parity. This means that over the long run, the exchange-rate adjusts to reflect the difference in price levels between countries. In theory, a given item will have the same price in two countries adjusted by the prevailing exchange rate.
Exchange Rate Movement Creates RiskExchange rate regimes have varied over time from fixed to floating or managed floats with central bank intervention in the foreign exchange market. The last period Australia experienced a fixed exchange rate regime was between 1944 and 1971. In 1944, western world leaders met in Bretton Woods, New Hampshire, to create the International Monetary Fund and the World Bank in an attempt to cope with raging economic and financial problems that occurred following the Great Depression and World War II. As part of the agreement, the value of the U.S. dollar, the key currency at the time, was fixed at a convertible rate of 1/35 of an ounce of gold. Central banks around the world were obligated to keep the exchange-rates of their currencies pegged to the dollar and its gold content, with variations limited to plus or minus 1%. The system later broke down when America suspended convertibility following sustained trade deficits that led to enormous reductions in its gold reserves. However, some countries are still tied to the US dollar with China being the largest and most well known.
The American dollar has also kept much of its reserve status for central banks and is still used to settle transactions in all major commodities. In the FOREX market, US dollars are involved in most transactions either directly or indirectly. Direct cross rates are only available for major currency pairs like GBP/AUD. For example, in order to obtain Thai baht for Indian rupees you would have to go through the US dollar, with it effectively acting as an intermediary currency.
The floating regime that we have around the world today brings about volatility and uncertainty and creates risk for all market participants. For example, when a UK wine merchant puts in an order to buy 1,000 cases of French wine, the merchant may agree to pay in euros, say 100 euros per case, when the vintage is ready for shipment in two years. However, over the next two years, the value of the pound could drop from 0.68 EUR/GBP to 1.0 EUR/GBP which raises the price of each case from 68 pounds to 100 pounds. Thus, pricing the wine in Euros exposes the UK wine merchant to a currency exchange-rate risk.
Of course, if the wine was priced in pounds (£68 per case) it would relieve the UK merchant from the currency exchange-rate risk. But now the French wine producer would suffer, as the value of the pound fell from 0.68 EUR/GBP to 1.0 EUR/GBP. In this example the French merchant would have to take the loss, which the UK importer had previously experienced.
Fundamental Versus Technical AnalysisWhile technical analysis concentrates on the study of market action, fundamental analysis focuses on the economic forces which cause prices to move higher, lower or stay the same. The fundamental approach examines all of the relevant factors affecting the exchange-rate between two currencies to determine the intrinsic value of each currency. The intrinsic value is what the fundamentals indicate one currency is actually worth against another currency. If this intrinsic value is under the current market price, then the currency is overpriced and should be sold. If market price is below the intrinsic value, then the currency is undervalued and should be bought. Both of these approaches to market forecasting attempt to solve the same problem; to determine the direction prices are likely to move. They just approach the problem from different directions.
A fundamentalist studies the cause of market movement, while a technician studies the effect. Most market traders classify themselves as either technicians or fundamentalists. In reality, there is a lot of overlap between the two. Most fundamentalists have a working knowledge of the basics of chart analysis. At the same time, most technicians have at least a passing awareness of the fundamentals. The problem is that the charts and fundamentals are often in conflict with each other. Usually at the beginning of important market moves, the fundamentals do not explain or support what the market seems to be doing. It is at these critical times in the trend that the two approaches seem to differ the most.
Usually they come back into sync at some point but by then, it is often too late for the trader to act. One explanation for these apparent discrepancies is that market price tends to lead the known fundamentals. Stated another way, market price acts as a leading indicator of the fundamentals and or the conventional wisdom of the moment. While the known fundamentals have already been discounted and are already "in the market," prices are now reacting to the unknown fundamentals. Some of the most dramatic market movements in history have begun with little or no perceived change in the fundamentals. By the time those changes became known, the new trend was well underway.
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