How currencies move and why

Exchange rates affect the returns on foreign holdings, the cost of imports and the competitiveness of exports, and they are notoriously resistant to forecasting.

What drives them

Several factors operating over different horizons.

Interest rate differentials: higher relative rates tend to attract capital, supporting a currency, though the relationship is not reliable and the carry trade has produced substantial losses when it reverses.

Inflation differentials: over long periods, higher relative inflation tends to weaken a currency, which is the basis of purchasing power parity.

Growth and productivity differentials.

Trade and current account balances.

Risk appetite: certain currencies strengthen during global stress as capital seeks perceived safety, regardless of domestic conditions.

Fiscal credibility, where concerns can produce sharp moves.

And central bank intervention in some cases.

Purchasing power parity

The long-run anchor.

The theory that exchange rates should adjust so that identical goods cost the same across countries.

Empirically, deviations from it are large and persistent, and reversion occurs over periods measured in years or decades rather than months.

Which makes it useless for short-term forecasting and a reasonable long-run anchor.

Informal versions comparing the price of a standardised product across countries illustrate the concept and are not precise.

Why forecasting is so hard

Even relative to other markets.

Currencies are relative prices, meaning both sides move.

They are influenced by policy decisions that are themselves difficult to predict.

Capital flows respond to sentiment and risk appetite, which shift quickly.

And academic work has repeatedly found that short-horizon exchange rate forecasts perform poorly against simple benchmarks, a finding that has proved durable.

Which means currency forecasts should be treated with even more scepticism than other market forecasts.

The safe haven phenomenon

Worth understanding.

Certain currencies have historically strengthened during periods of global stress, regardless of the source of the stress.

Which produces a useful effect for investors in those currencies: foreign holdings fall in value in local-currency terms during stress while the domestic currency strengthens, compounding the loss.

And a useful effect for investors elsewhere: a weakening domestic currency cushions the fall in foreign holdings.

Which is why unhedged foreign equity exposure behaves differently for investors in different countries.

What it means for a portfolio

Practically.

Equity holdings: currency volatility is smaller than equity volatility and provides some diversification, so unhedged exposure is common and defensible.

Bond holdings: currency volatility exceeds bond volatility and defeats the purpose, so hedging is standard.

Cash: hold in the currency you will spend.

And money needed soon: remove currency risk regardless of asset class.

The costs of conversion

A practical point that costs real money.

Retail currency conversion frequently carries a margin embedded in the rate rather than disclosed as a fee.

Which can be substantial, particularly on regular transactions.

Comparing the total amount received rather than the stated fee is the only reliable comparison.

And using funds denominated in your own currency, even where they hold foreign assets, avoids repeated conversion.

For people with cross-border lives

Where it matters most.

Income in one currency and commitments in another creates exposure that can be substantial.

A mortgage in a foreign currency is a well-documented source of hardship when rates move, and has been restricted in several jurisdictions.

Retirement plans involving a different country need to account for exchange rate movement over decades.

And holding savings in the currency of eventual expenditure reduces risk rather than increasing it.

What not to do

Where currency becomes speculation.

Attempting to time currency movements.

Holding foreign currency as an investment, which produces no return and carries volatility.

Leveraged currency products, which regulators restrict for retail investors and where disclosed retail loss rates are high.

And changing hedging policy in response to recent movements, which is performance chasing applied to exchange rates.

The practical summary

For most investors.

Accept currency exposure on global equities.

Hedge bonds.

Hold cash in your spending currency.

Minimise conversion costs.

And do not attempt to forecast, since the professional record suggests it is not achievable.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.