Classic Example of how exchange rates work

The past couple of weeks have provided a prime example of how exchange rates are calculated and what internal and external factor effect their movements. What has happened in Russia recently typifies many of the causes and reactions of the markets to any sort of change.

We are all aware that originally it was the sanctions placed on Russia over their actions in the East of Ukraine that put pressure on their economy and drove them towards negative growth and ultimately recession, however the fall on oil prices has had a much more significant impact on the country’s fortunes.

Russia’s reliance on oil and gas exports can not be understated with the country’s coffers receiving 45% of its income from the taxes on oil and gas revenues. Like any country the Russian government produces budget forecasts and has to predict an oil price to do this. Currently next year’s budget is based on selling its reserves at $100 to meet its commitments but with oil prices falling by almost 25% to $88 and predicted by some to reach $65 a barrel, Russia will struggle to pay its bills.

As we mention in our  “how exchange rates are calculated” page, interest rate parity is based on the current state of a country’s finances and the future prospects of a country’s finances. With the stock market dropping over 20% in the past two days and the ruble nearly halving in value over the past year it is easy to see that with further falls in the oil price on the cards there is not much on the horizon to help secure the currency.

The other impacts are the country’s central bank’s interest rate, which Russia raised to 17% last night, from 11.5%, in a bid to stop any further falls by the ruble by attracting inwards investment but with inflation threatening to hit double digits this increase is quickly eaten into.

So you can see in this extreme case exactly how the following has an impact on the value of a country’s currency:

  • Interest Rates
  • Inflation Rates
  • Economic Stability
  • Spot Rate
  • Future Rate

Forward governance just got a little more hard to predict.

When the new governor of the Bank of England enter the bank he reassured the financial markets that his method of forward governance would put an end to the uncertainties of the markets in regards to the decisions it made. To back this up he laid down a list of criteria, such as job numbers and inflation levels that would have to be met in order for them to consider raising the UK’s interest rates from their current historic low levels.

This all sounded fantastic at the time and home owners across the country slept easier know that they would at least have a degree of heads up before rates started rising, and then they would be a slow incremental rates.

However if anything the markets have been more unpredictable than ever, with surprising and unexpected inflationary numbers, unemployment numbers, consumer confidence levels and overall health of the UK and further afield seemingly changing on a daily basis. Only a couple of weeks ago, following the fall in unemployment, we were all being warned that rates would have to go up this year rather than in 2015 as previously though. Then we had unexpectedly low inflation figures, which prompted experts to change tact and predict that we wouldn’t see a rise until after the general election 2015.

This is why it is more prudent not to try to second guess the markets and just make sure that in either eventuality you are covered financial and emotionally.

The beauty of hindsight

This month has shown how volatile the markets can be and catch anyone unawares and turn their lives upside down. Following the Scottish referendum in Scotland the pound rallied in response the “no” result only for it to be hit by unexpectedly low inflation numbers. The fall from 1.5% to a five year low of 1.2%, mainly as a result of the continued fall in oil prices, has had a knock effect as it immediately sounds the death knell to any change of an interest rate hike in the UK until 2015. This has sent sterling into free fall as the markets were looking for a rise in rates as soon as this quarter 2014.

However falling Sterling will be welcomed by British companies that do business abroad as two companies today have announced a hit in their profits due to the strength of the Pound. Michael Page announced that even though their gross profits had grown by 11.6% once exchange rates, converting foreign earnings back into Sterling, their gross profit as actually 4.7%. This has resulted in a drop in their share price of 7.6%.

Mulberry is another company that has been hit by their success abroad as exchange rates negatively impact their earnings.

Currencies race to the bottom

This week sounded the starting gun for currencies as central banks around the globe try to kick start their economies using their monetary policies to weaken their currency values in the hope that this will boost their exports. The Kiwi dollar has fallen 4% in the past month as is set for further falls following their Prime Minister’s, John Key, admission that the country’s currency is too strong.

The Eurozone is set to do the same after successive cuts in interest rates have failed to boost bank lending ,mainly as there is no one wanting to borrow money due to poor sentiment. Therefor the only means left to the Central Bank is to follow the UK and US’s lead of using quantitative easing to buy up bonds in the market, therefore realising funds for other investment.

On the flip side the US and UK are looking to scale back their fiscal easing policies in anticipation of stabilising their economies so that they do not overheat after years of easy money and low interest rates.

Russia however is preparing to step in and offer support for their currency, as it hits a new record low, as sanctions take their toll on the country’s access to financial markets.

Money flows out of Eurozone

Yesterday’s financial markets spoke volumes about where the world see’s the safest place for its money. The S&P broke above the 2000 mark for the first time in its history, buoyed by a surge in Biotech stocks and noises from the Fed that an end to their money printing and low interest rates are here to stay due to low inflation figures and stubbornly high unemployment. Money also flowed in the other direction, as the Hog Kong index reach 25,166.91 points, its highest since the financial crash of 2008.

The fact that these two indices did so well just as the Eurozone suffers yet another stumbling block, in the collapse of the French government, shows that the Eurozone is not seen as an ideal place for investment at the current time.

Down with the Pound

The Pound fell to its lowest point against the Dollar in 2 months this week as murmurings from the Bank of England have analysts betting on a rates rise this November, which would impact the value of Sterling. However expectations are that the rises would be gradual but the Governor couldn’t rule out certain “events.”

But with Growth in Europe and Japan and a virtual standstill Sterling still looks a strong bet.

The Pound set for a fall?

The International Monetary Fund, IMF, has come out this week and said that Sterling is overvalued by up to 10%. Analysts put this down to the booming housing market and the troubles faced in Europe and further afield.

Despite this Sterling remains at a two year high against the Euro and has appreciated over 10% against the USD over the past twelve months, with some forecasting a Dollar rally and a Sterling slump.

A raising of UK interest rates is also waiting in the wings and this could help cool the housing market and the value of Sterling.

Prices soar above expectation

The UK released its monthly inflation figures this morning and they caught the markets off guard by being quite a lot higher than expected. The consensus was that we were going to see a rise but only to 1.6%, but the actual figure was 1.9%, only a shy under the Bank of England’s target rate of 2.0%. The office of National Statistics was at a loss to explain exactly what had caused this, but hinted at rising food prises and transportation costs. However it could be just a case of people in the UK spending more and coincides with a rise in retail sales in June by 0.6%.

This means that although the pound has risen strongly against the Euro and the USD over the past year, resulting in cheaper imports, the overall cost of things in the UK has risen. This will add to the cost of UK exports and could result in less demand for Sterling in the future.

After Dinner Mint

Mark Carney gave a bitter pill for everyone at this years annual Mansion House speech in the City of London by warning that interest rates could move quicker that the financial markets expected. Up until now the consensus was a rise in Spring 2015 however this comment has moved the favourite to November 2014. This had an immediate effect on Sterling as it breached the 1.70 to the USD for the first time since 2009, bolstered further as a safe haven as things escalate in the middle east.

The USD took a further bashing as the IMF cut its growth forecast for the US from 2.85 to 2% and urged the government to do more to support the economy such as raising the minimum wage and keeping interest rates low.

Make hay while the sun shines

The Daily Mail today released a chart of the annual change in exchange rates for the most popular holiday destinations.

CurrencySummer 2013Summer 2014Change
Euro1.171.23+5%
US Dollar1.521.68+11%
AUS Dollar1.581.80+14%
Thai Baht46.1654.70+19%
Turkish Lira2.863.51+23%
Egyptian Pound10.6211.95+13%
Mexican Peso19.4621.64+11%

As you can see you are well over 5% on your holiday money wherever you choose to go in the world with Turkey offering a whopping 23% improvement on your rate this time last year, so book your holiday money today!

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