How does the global currency market work?

How does the global currency market work? 

Currency markets may seem simple enough to understand when you are only looking to exchange money from one currency to another for a holiday, but what drives those currency prices up or down is wider ranging than you might imagine. 

For people making one-off purchases of a low value, it is less important to monitor currency moves. But if you are a business or individual sending money regularly across borders in large amounts, what is driving the price of the currency you need to deal in is very important. 

In this article, we'll take a look at how global currency works and what can make currencies rise and fall, sometimes very quickly and without warning. 

Currency pairs 

One thing to remember about currencies is that they are always quoted in pairs. That’s because the value of one currency can only be measured in the moment against another. For example, if the US dollar strengthens – which means it becomes more valuable against other currencies – then by definition, another currency measured against the US dollar would become ‘weaker’ or relatively fall in value. But that does not mean it is weakening against other currencies, it could actually be strengthening. You can check the exchange rates between all currency pairs from various different sources, including the Xe Currency Converter, your bank, or other websites like The Times currency converter. The major currency pairs worldwide are: 

• GBP/USD sterling vs US dollar 

• EUR/USD euro vs US dollar 

• USD/CHF US dollar vs Swiss franc 

• USD/JPYUS dollar vs Japanese yen 

• AUD/USD Australian dollar vs US dollar 

• NZD/USD New Zealand dollar vs US dollar 

• USD/CAD US dollar vs Canadian dollar 

These are the currency pairs that most cross-border payments are made in worldwide. Many of these are measured against the US dollar as it the most used currency globally – it is known as the ‘world’s reserve currency'. Some countries will even trade in US dollars if it is more stable than their own currency, or easier to use to trade elsewhere. This is the case, for example, in China and some areas in the Middle East.

However, when things are not going well for, or are unsettled in, the US, other currencies become what are known as ‘flight-to-safety’ currencies. These traditionally have been the Japanese yen, the Swiss franc and, more recently, the euro has been acting as the world’s safe currency. 

What affects the movement of currency pairs? 

There are many things that affect the movement of currency pairs, and it is not always easy to differentiate between them when lots of things are happening at the same time. The main things that affect currency values are: 

• Politics 

• Economics 

• Interest rates 

While each of these can be taken in turn, they are rarely acting separately as each is intrinsically linked. 

Politics 

The political influence on currency rates is one of the most difficult to predict, especially when major political moves are involved. There are some excellent examples in recent years that illustrate this perfectly: 

Brexit 

The UK’s surprise vote to leave the European Union back in June 2016 is perhaps one of the most perfect examples of a political decision impacting currency that you can see. 

The vote itself was on June 23, 2016, and prior to this date sterling had been relatively strong against other currencies. On June 22 that year, £1 would buy you nearly US$1.47 and €1.30. But on June 24 after the Brexit vote result was known, the pound fell to US$1.36 and €1.22. 

This was an 8% fall on a single day against the US dollar, the biggest fall in any of the four major currencies since the free-floating exchange rates were introduced in the 1970s, according to Reuters. And this was a direct result of a political vote that shook the UK – and to a lesser extent the EU – not just in that year, but for many years since. 

The fallout of that vote has continued to affect the value of the pound going forwards and it has yet to return to the levels it had reached prior to the Brexit vote, let alone the heady days when you could get US$2 to the pound. A number of times as the Brexit negotiations played out, and since the UK actually left the EU on December 31, 2020, the pound almost reached parity with the euro. But there would have been other things influencing these currency pairs during these times too.   

President Trump’s election victory 

When Donald Trump got elected as President of the United States, beating Hillary Clinton, who was the favoured candidate winning the popular vote despite losing the all-important Electoral College vote, the first reaction of the US dollar was to weaken against the Japanese yen. 

In overnight trading, as the victory looked to be heading toward Donald Trump, the US dollar fell as much as 4% against the Japanese yen according to Reuters, before it recovered ground. 

President Trump’s protectionist trade policies, and the ensuing trade war with China which resulted from the imposition of trade tariffs – a policy also expanded to Canada, Mexico, and the EU’s trade with the US during this period as well – had a negative impact on both the value of US gross domestic product (GDP) – which is the primary measure of output of a country – and employment figures. 

The tax cuts expected at the beginning of his presidency boosted trade initially. But the US dollar fell in value by around 10% from the beginning of 2017 when President Trump was inaugurated, to November the same year. This was despite rising interest rates announced by the US Federal Reserve during this same period. 

These conditions would typically result in a stronger US dollar, but the divisive Trump rhetoric, events such as those in Charlottesville, plus the uncertainty surrounding the position with North Korea at the time, along with the prospect of budget stand-off with Congress, meant the US dollar was acting in an atypical way. 

These political machinations present another perfect example of how politics can impact currency, especially in a way that you may not expect a currency to normally behave. 

Economics 

Sometimes it can be difficult to split the economic impact on currency from political impact as they are so intrinsically linked. But there are some specific examples of how economic conditions precipitated by political decision-making hit currency values. 

The UK’s ‘mini-Budget’ 

During the short-lived and hugely unsuccessful 45-days of Liz Truss’s premiership in the UK, some serious economic damage was inflicted as the result of a disastrous and inaptly named ‘mini-Budget’ presented by her short-term Chancellor, Kwasi Kwarteng. 

Measures such as removing the UK’s top rate of income tax which stands at 45% and reducing the basic rate of income tax from 20% to 19% were badly received by the markets as the Chancellor chose not to announce them alongside an independent review of the UK’s finances from the Office for Budget Responsibility. 

As a result, they were widely seen as being ‘unfunded’ which led to a precipitous drop in the markets, reduced international trust in the UK government, and the consequent intervention by the Bank of England to buy up government bonds to boost their price and keep yields at a reasonable level.  

Failing to do this would have led to pension funds in particular, which use the longer-term 10 to 30-year bonds to plan for their liabilities going forwards, facing a black hole in their finances and in some cases failing. 

Unsurprisingly against this backdrop, the pound also fell off a cliff. On September 22, 2022, the pound was at US$1.12 and €1.14 but after the mini-Budget on September 23, it had dropped to US$1.09 and €1.12. By September 27, it was down to US$1.07 and €1.11 and even reached a record low against the US dollar before recovering. 

Most measures announced by Kwasi Kwarteng were reversed within a month when the new Chancellor Jeremy Hunt made an Emergency Statement on October 17, 2022. This helped to settle the markets, and the pound rallied on the day by around 1.1%. 

The Covid-19 pandemic 

Covid-19 led to nearly complete worldwide lockdowns which resulted in economies almost grinding to a halt – it is a period that those who lived through it are unlikely to forget. 

Again, the political decision-making was one of the biggest drivers in how economies fared globally, as some countries such as Sweden chose not to lockdown to anywhere near the same extent as other countries such as Spain, France, China, the US and both Australia and New Zealand. 

The first lockdowns began in China, but most lockdowns elsewhere began at some point during March 2020. Britain was relatively late to limit movement in its population, while others such as Australia, New Zealand, and Canada prevented the freedom of movement of citizens within their borders and across borders for longer than most other countries. 

During such a time of uncertainty, it is little wonder that the world’s flight-to-safety currency, the US dollar, strengthened considerably. For example, on March 7, 2020, the US dollar sat at US$1.30 to the pound. By March 23 the same year, it had strengthened to just under US$1.15 to the pound.  

Economies were still recuperating from the pandemic effect more than a year later, but many had recovered to a greater or lesser extent towards the end of 2022. The fallout continued with rising inflation, higher interest rates and some countries struggling to return to their pre-pandemic levels of GDP. Global growth hit 5.5% in 2021, but it is expected to fall to 4.1% in 2022 and 3.2% in 2023 according to The World Bank. The fall is down to pent-up demand built during the pandemic dissipating. 

There are still concerns over Covid-19 as we head into 2023 and as central banks unwind their support for economies, coupled with ongoing political uncertainty due to the war in Ukraine, how the global economy will continue to be affected remains to be seen.

Interest rates

Rising interest rates tend to go alongside rising currency rates because when rates rise, countries become more appealing to investors and that helps to strengthen a country’s currency. 

Interest rates are often increased to help control inflation. It is a way of reducing spending and encouraging saving within the population. But it can create complications if, for example, a country’s population and businesses have high levels of debt. Any increase in interest rates puts up mortgages, credit card rates and business loan rates which can negatively impact the economy in the longer term. 

It is a difficult balance to maintain. For example, the US Federal Reserve, the UK’s Bank of England and the European Central Bank all raised interest rates aggressively towards the end of 2022 in a bid to stem inflation which was being driven largely by rising energy and food prices. 

The correlation between these rises and currency strengthening is clear. For example, the US Federal Reserve raised rates on November 3, 2022, and on that day the pound was worth US$1.11. By November 4, the US dollar had strengthened to just under US$1.14.  

Speak to an expert 

There are so many things that combine to affect a currency price and many of them are acting simultaneously. So, if you are unsure how to get the best rate for your transfer, you should speak to an expert.