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
  1. 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.

Thank you for listening to today’s episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact

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