Inside the currency markets: 5 factors that influence exchange rates

Exchange rate fluctuations and their impact on international payments are common knowledge – such as a surge in the pound’s value against the euro increasing the purchasing power of British property buyers in Spain – but what many of us are less certain about is the factors that pull the markets back and forth.

To shed light on this often-confusing set of variables, let’s scratch the surface of the currency markets to demystify the top five most influential ones.

Inflation

Inflation measures how much more expensive a set of goods and services has become over a certain period, usually a year. When a country or currency zone is experiencing high inflation, it will typically experience a drop in the value of its currency. That’s because high inflation makes the price of goods and services less competitive.

If, for example, inflation remained low in the UK, the purchasing power of the pound would increase relative to other currencies. UK exports would become more competitive, causing demand to purchase the pound for UK goods to increase. 

The Consumer Price Index (CPI) is the most widely used gauge of inflation and is closely monitored by policymakers, financial markets, businesses, and consumers. It measures the overall change in consumer prices based on a representative basket of goods and services over time.

Interest rates

According to the Bank of England (BoE): “the interest rate is the amount you are charged for borrowing money, shown as a percentage of the total amount of the loan. The higher the percentage, the more you have to pay back for a loan of a given size.”

These borrowing costs are set by central banks, like the BoE, the European Central Bank (ECB) and the US Federal Reserve at their monetary policy meetings – which they each hold eight times a year. Their accompanying announcements make headline news, partly because of the huge influence the resulting interest rate has on demand for a particular currency – and, therefore, the exchange rate.

Generally, higher interest rates increase a currency's value. That’s because they attract more overseas investment, which means more money coming into a country and higher demand for the currency. The opposite relationship exists for decreasing interest rates.

There is a strong correlation between inflation, interest rates and exchange rates. Higher interest rates are a central bank’s main weapon in the battle against rising inflation as they help to slow down price rises by reducing how much is spent across the country. The impact of higher interest rates is mitigated, however, if inflation remains much higher than in other countries.

If, for instance, the Federal Reserve hikes interest rates, they will make holding onto dollars more profitable, increasing investor demand for the US currency – causing its value to rise. Conversely, if they cut interest rates, the dollar could fall in value. What’s more, mere speculation of a rise or cut in the interest rate could cause the currency concerned to spike or slump, as investors take pre-emptive action.

Consult a currency specialist to get expert insight into the impact of these variables on your exchange rate.

Purchasing Managers’ Index (PMI)

These monthly survey-based indicators of business conditions in key sectors measure economic factors, including individual business output, new orders, employment, costs, selling prices, and exports. Major business executives are asked to report the change in each variable compared to the prior month, noting whether each has risen/improved, fallen/deteriorated or remained unchanged.

The Purchasing Managers’ Indexes are the results of these monthly surveys. They are considered an accurate and timely indicator of business conditions that help analysts and economists to anticipate shifting trends in economic data such as GDP, employment and inflation. Their results are represented by a score between 0 and 100 – 0-49 shows the economy is contracting, 51-100 shows it’s expanding and 50 indicates no change.

Because these PMI surveys are sometimes printed months in advance of comparable official data, they are widely considered among the most influential economic data releases on exchange rates. Two PMIs from the UK economy typically have the biggest impact on the pound: construction and services.

Manufacturing PMIs are generally released on the first working day of the month, construction PMIs the next day and service PMIs the day after. A negative PMI is a key factor in making an exchange rate drop in value, reflecting a shrinking economy. So, if the PMI moves well above 50, you can expect the exchange rate to move up amid a growing economy.

Non-farm payrolls and earnings

A country’s average earnings index – known as non-farm payrolls in the US and Canada – analyses the levels of pay across the economy, showing whether they’re going up or down.

These influential data releases are closely analysed against forecasted figures. If the printed figures are much lower than expected, they might be considered a signal of a downturn, denting investors’ confidence in the economy. This can cause the currency to depreciate, as they sell it in favour of a stronger one. Conversely, if these numbers exceed expectations, then you can expect the currency to appreciate as demand to buy it grows.

Current account/balance of payments

A country's current account reflects the difference in value between payments heading into and coming out of a country or currency area, such as the Eurozone. A summary is published every month, which can impact the exchange rate – a bit like a national balance sheet, with income and outgoings.

For example, if the UK has a deficit in its current account its imports are worth more than its exports. This means it’s spending more of its currency on importing products than is being sent into the country to purchase its exports – resulting in a negative balance of payments. When more sterling is being sold than bought, the pound falls in value because investors can see there’s a low demand for sterling and a high demand for another currency like the euro or dollar.

Influential factors combined

These factors don’t push and pull on all currencies in isolation. For example, hot inflation might weigh on the dollar, but strong payroll data supports it. These are factors that influence exchange rates monthly, but other significant forces can appear less frequently, such as elections and recession, or unexpectedly like the pandemic.

It’s this inherent uncertainty in the currency markets that makes it impossible to accurately predict which way they might move. If you’re sending a large sum of money overseas, perhaps to make a property purchase, or you’re regularly transferring money from one currency to the other, then you must shield your payments against currency risk. A forward contract does just that by enabling you to secure a current, favourable exchange rate for future transactions – so you know exactly how much they’ll cost when the time comes to make them.

Find out how a currency specialist can help you navigate the unpredictable currency markets.