Exchange rates are constantly moving, based on supply and demand. Whether one currency is in higher demand than another, depends on the perceived value of owning it, either to pay for goods and services, or as an investment.
What are exchange rates?
An exchange rate tells you how much of a country’s currency you could buy for each unit of another currency. For this reason, exchange rates are expressed as currency pairs.
One of the most commonly quoted currency pairs is GBP/USD – the British pound and the US dollar.
If the market rate for GBP/USD is 1.25, for example, you’d get US$1.25 for each £1 you exchange (assuming you get the market rate, and excluding any fees).
You can flip the equation. So, at the same time, the USD/GBP rate might be 0.80, meaning you’d get £0.80 for each US$1 you exchange.
The rate can make a big difference to the amount you get from a currency exchange. In the 18 months between 1 January 2018 and 1 July 2019, £1 was worth US$1.42 at its highest and US$1.22 at its lowest. That’s a difference of US$200 for every £1,000 exchanged at the market rate:
- GBP/USD exchange rate = 1.42: £1,000 = US$1,420
- GBP/USD exchange rate = 1.22: £1,000 = US$1,220
What drives demand for a currency?
But currencies are exchanged on a much greater scale for other reasons, including trade – buying goods and services from another country – and investment.
The rising value of a country’s currency versus others may be an indicator of improving economic health. Or at least the prospect of it. If GBP is rising against the USD, for example, it’s in higher demand at that time.
Below are some of the key influences on exchange rate movements.
Interest rates and inflation
Inflation and interest rates are closely related, and both affect exchange rates.
Some inflation – rising prices of goods and services – is healthy for an economy, as it shows increasing demand versus supply. But too much inflation can be a problem, as goods and services become less affordable.
Central banks consider this balance when setting interest rates. For example, the Bank of England has an inflation target of 2%, as of 22 May 2020.
If inflation is below its target level, a central bank may look to cut interest rates. Lower interest rates make it cheaper to borrow, and less rewarding to save, which encourages people to spend. That increase in demand can push inflation higher.
But if inflation is rising too fast, a central bank may increase interest rates, aiming for the opposite effect. Higher rates can make it more expensive to borrow, and more rewarding to save, reducing demand and slowing inflation.
Higher interest rates can increase a currency’s value. They can attract more overseas investment, which means more money coming into a country and higher demand for the currency.
A country’s trading relationship with the rest of the world can also affect its currency. Countries that export more than they import – known as a trade surplus – will typically have stronger currencies than those with trade deficits.
If businesses outside the UK buy goods and services from the UK, for example, they’ll typically pay for them in pounds. The more a country exports, the higher the demand for its currency will be.
Market expectations – taking into account the above factors – play a big part in exchange rate fluctuations.
But an unexpected interest rate cut, or increase, could have a more pronounced effect on exchange rates.
The Bank of England holds regular Monetary Policy Committee meetings, where it decides whether to raise, cut, or leave rates unchanged. Similarly, in the US, the Federal Open Market Committee (FOMC) holds regular meetings to discuss monetary policy, including interest rates.
- Bank of England Monetary Policy Committee dates 2020
- US Federal Reserve monetary policy meeting dates 2020
Other economic data, such as Gross Domestic Product (GDP) and unemployment rates, will also affect market expectations.
The stability of a country – economic and political – does too. The outcome of an election, could have a significant impact on a country’s currency, if the market expects it to result in faster or slower economic growth.
How to manage currencies
If you’re managing money across multiple currencies, it helps to stay up to date with currency movements.
HSBC’s FX app gives you access to live market updates and historical rates. It also lets you trade currencies and set up limit orders – that’s where you name the rate you want, and the trade happens as soon as that rate is available.
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