Because we know he’s a sucker for a challenge, we recently asked our Head of Trading to sum up why the Foreign Exchange markets move… in one sentence!
Greg’s “you’re crazy” look, was quickly replaced by a determined furrow of the brow and: “It is all about supply and demand. At any point in time if demand beats supply, then the market is mechanically going up”.
If only it was that simple.
As we said in our first “How the foreign exchange market works” blog a couple of weeks ago (check it out if you haven’t already), this is a complicated area. So let’s take a look at what moves the markets in digestible chunks. Chunks that you don’t need to be an economist, mathematician or expert to understand.
To start with, who are the players who move the market?
Moves in the market are caused by vast amounts of currency being bought or sold. These are the groups doing the buying, and doing the selling…
- Banks are managing their own accounts, facilitating orders from clients and investing their treasury (mostly your deposits).
- Funds and Institutionals seek good returns for their clients’ money and investing in the right currencies is part of portfolio allocation.
- Corporates generally seek to minimise currency exposure in any foreign currency, and some of them might be looking to place extra liquidity. They plan for future imports, and manage proceeds of exports.
- Individuals, unfortunately do not really count in there…
So why do we buy currency?
Unlike Uri Geller (or maybe just like Uri Geller) we don’t possess mind-reading powers here at WeSwap (annoyingly), but we reckon your first thought was: “to go on holiday with”. Of course, you’re right. As travellers/consumers, that is what we’re most concerned with – getting money for our jollies. Another reason might be to pay someone in a foreign country, or to buy foreign goods.
But businesses like banks, hedge funds and corporates buy currencies on a much larger scale. That’s because they are trying to manage their own portfolios. Both for profits and to diversify their own risk. They may decide that one currency has greater value or carries less risk than another asset they already own. That asset could be anything from another currency, to stocks & shares, to tangible commodities – like gold.
Secondly, why do we sell currency?
Again, as travellers, the obvious answer is when we return from our holidays with left-over Euros, Dollars, Lira, Yen, or whatever else we have leftover in our wallets.
Another time you may have a foreign currency to sell is after you sold something in a foreign country. If you sell a house in Spain, you’re going to get paid in Euros and you may want to exchange it back to GBP.
Or maybe, on a generally bigger scale, you own that currency for whatever reason (previous investment, proceeds of a sale) and now you don’t think it offers, or will offer, the best risk/returns for your particular situation: you think it might lose some of its value (think having Euros when Greece was having problems), or it bears too much risk (having 100% of your wealth in GBP when you plan to retire in Portugal). It might be that you want to diversify your portfolio and unload a bit of one particular currency.
So I buy or I sell based on an assessment of the risk and the return of a currency. But how do I measure that?
Big players are looking for returns from their investments. This applies to people investing in currencies too. For a given level of risk tolerated, they seek the best value they can get in the markets.
For currencies, this value is primarily measured by the interest rate it distributes, just like a stock would pay dividends.
The higher a currency’s interest rate is, the more money you will get. It’s better to deposit 100 in currency X that earns you 10%, than in currency Y that pays 1%. As long as you don’t expect X to lose significant value by the time you collect your money back. As in, I’ll pay you with a big ice cream which would have melted by the time you actually receive it.
In terms of risk, invest in the currency of a country that is economically and politically stable with steady growth and inflation if you want to lessen the overall risk of your holdings – this will generally pay less, though.
As a Brit, the day before Trump’s election, you would be better off with Japanese Yen in your pocket rather than USD, because you don’t know what is going to happen. Unless you like to gamble of course. Yen also improved vs the Pound throughout Brexit because investors identified it as a safe haven.
Game-changers. What are the developments that lead to “the players” suddenly buying or selling?
Specialists in the market pay attention to many different areas and ultimately make speculations over what is about to happen.
These crudely split into two categories:
1. News and economic releases that hint at moving interest rates (Central Bank rate decisions, inflation reports, unemployment reports, GDP numbers, oil prices).
2. Changing risk environment (elections, geopolitics, terrorist threats, economic agreements).
Each news item will influence the appetite for a currency, that will start moving one way or the other And then the momentum comes into play: you just need a rumour that a large hedge fund is now buying and everyone is off to the races, thinking it must have some good reasons.
Anything still a little unclear? Let us know your thoughts in the comment section below and we’ll give you a speedy answer. Keep your eyes peeled for our third installment: “Is there a good time to exchange currency” coming soon.