The landscape of global currency markets and the varying factors that influence them can be complex and daunting. Nevertheless, there are proactive measures businesses can take to shield their operations and bottom line from impactful external forces.
Financial publications are full of stories of the challenges facing international businesses due to foreign exchange rate fluctuations. The dollar had a historic rally as the US central bank (the Fed) pursued an aggressive tightening cycle. After gaining nearly 25% the dollar reversed course and is currently 10% below the high reached in September 2022. Analysts express mixed views on the next big move, but most agree that volatility will continue in 2024. Which means that companies exposed to foreign exchange rate risk need to understand the primary factors affecting currency pricing and volatility. And what are these factors?
1. Interest Rates
- Higher interest rates generally attract foreign capital, which strengthens the receiving country’s currency. Whereas lower rates usually result in lower prices.
- Central banks' monetary policies and interest rate decisions significantly impact currency valuation. For example, bucking the trend of most major central banks, the Bank of Japan (BOJ) has held a negative interest rate policy in 2022-2023, whereas other central banks sought to curb inflation by aggressively raising interest rates. The result has been a weak yen, currently trading near 20-year lows.
- The interest rate differential between two currencies is also a critical factor in determining the cost of hedging the FX pair. For example, to seek protection against the Mexican peso losing ground to the US dollar, a hedger would have to pay the difference between Mexican rates, currently 11.25% and US rates of 5.5%.
2. Inflation Rates
- Inflation is the rise in prices of products and services over a set period of time. This rise in prices means that one’s money experiences a loss in its purchasing power. The currencies of countries with higher inflation tend to weaken compared to currencies with lower inflation.
- The classic central bank policy to reduce unwanted inflation is to raise interest rates. Higher rates generally work in two ways: 1) High interest rates slow economic activity and bring down demand for goods and services, and 2) Higher rates attract foreign money seeking a higher yield, which discourages speculation against the currency (entities that are short the currency have to pay the interest rate differential to hold the position).
3. Foreign Exchange Rate Market Supply and Demand
- Trade balances, the difference between the value of imports and exports, can also affect the price of a currency. Countries that export more than they import (positive trade balance) generally have stronger currencies than those countries with a negative balance.
- Foreign investment can have a significant impact, as capital flows, investments and direct foreign investment can push a currency higher. Conversely, money flowing out of an economy will result in a lower price for a currency on FX markets.
- Central banks can use tools other than interest rate changes to affect the value of a currency. Direct intervention (buying or selling the currency in the FX market) can influence pricing and volatility. Central banks can also utilize mechanisms like capital controls to limit flows in and out of their currencies.
- International economic events like wars or regime changes, commodity price fluctuations, and changes in crude oil prices are also directly correlated to the value of currencies and their volatility.
As a rule, highly liquid currencies that are openly traded in global FX markets tend to have lower volatility than currencies with lower volume. The spreads (difference between prices to buy and sell) on major pairs are much narrower than their less-traded counterparts.
The latest series of reports on inflation indicate that global central banks are likely to cut rates in 2024. Who cuts rates and by how much will undoubtedly be part of the narrative driving foreign exchange rate market movement and volatility as we move into the new year.
Pangea understands exactly how each of these factors impact not only FX rates, but your businesses. That’s why Pangea made the first end-to-end FX management solutions for businesses of all sizes. With Pangea, you can hedge FX, send international payments, store and receive foreign currencies with FX Smart Wallets, and more, all from a simple and intuitive platform.
You don’t have to merely brace for the impact of foreign currency volatility. Instead, you can manage your FX just like Fortune 500 companies—without the increased headcount and cost of banks and consultants.
Schedule a demo today and get the predictability and control you deserve going into 2024.
Pangea Prime: Predictable, simplified FX management.
