Up, down, left, right – What drives currencies?

A country’s currency has great economic importance. Let’s take the UK, and the British pound. The exchange rate informs us of the purchasing power per pound, it contributes to the competitiveness of UK businesses, determines the prices of goods and services imported, and flows into inflation. Meanwhile, it also informs part of international investors’ decisions as to whether or not to invest in UK assets, including government debt, as returns will vary dependent on currency moves.

First and foremost, for floating exchange rates, the double-sided nature of a currency pair means that a country’s currency e.g. the British pound against the US dollar, can be determined by moves in the pound or the US dollar, or both simultaneously. More often than not, multiple factors are in play at any given time, such that a change in the exchange rate is the relativity of those factors. This dynamic can cause exchange rates to appear puzzling.

Those key drivers are:

• Interest rates: Higher relative yields support the demand for a currency due to the better returns on offer. Those higher yields are often associated with the expected real path of interest rates and therefore the relative stance of inflation and the two countries’ central bank policy.
• Trade: A persistent trade deficit can weigh on a currency’s performance by requiring ongoing external financing of that deficit. In other words, when a country imports more than it exports, the demand for foreign currency (imports) is greater than the demand for the domestic currency (exports). Conversely, a trade surplus can be supportive of a currency.
• Fiscal policy: Large, persistent, fiscal deficits can undermine a currency if the sustainability of a country’s debt comes into question. Some countries, like the UK, rely on overseas investors to buy sterling denominated government debt, which can cause volatility in yields as well as the currency.
• Sentiment and capital flows: Inflows of capital such as foreign direct investment or other asset purchases boost demand and support a currency. That demand can be reinforced by positive sentiment around the current and prospective outlook. Investors and businesses look to the economic growth outlook, management of inflation and path of interest rates, and fiscal sustainability, to determine how much to invest and therefore demand of the currency.
• Commodity prices: Some economies are more reliant than others on commodity production and exports. This creates heightened currency sensitivity to movements in those commodity prices. This is especially true for some emerging market currencies.
• Risk appetite: Currencies have different sensitivities to movements in risk appetite. Some currencies are viewed as safe havens, strengthening when the global economic or political outlook is more challenging. Other currencies fare better when the global economy is strong, and geopolitical risks are low.

Drivers of a country’s currency do not always point in the same direction, and at different points in time, the relative importance of these drivers can change. For example, at times, interest rate differentials may the dominant driver, but at other times, perhaps it is geopolitics or fiscal policy. These dynamics add to the complexity of understanding movements in an exchange rate, but can also create bouts of volatility, such as the depreciation in the British pound after the 2022 “mini-budget”, which drove fears of fiscal instability.

Overall, trade, capital flows, and fiscal positions set the underlying supply and demand – and therefore, value - of a currency, while changes in expectations of relative interest rates, sentiment and uncertainty can drive short-term movements in an exchange rate. For businesses that trade overseas, understanding what drives a currency and which factor is in the driving seat at any given time is crucial. HSBC clients can subscribe to receive briefings from our currency strategists, who provide analysis and forecasts for all the major currencies.

Currencies are volatile, understanding what is driving them is essential for businesses