Fundamental analysis for currencies: what moves an exchange rate

Every currency is quoted against another. A pair can rise because the first currency is wanted, because the second is not, or both. A fact about one country matters to a pair only in comparison with the same fact about the other.

The forces below work together, over different lengths of time, and sometimes against one another. Interest rates and sentiment tend to show within days. Inflation and the balance of payments work over years. At any moment one of them usually has the market’s attention, and which one it is changes.

One more thing sits over all of them: prices move on what is new. What is already expected is, as far as anyone can tell, already in the price.

Money held in a currency earns that currency’s interest rate. Other things being equal, a higher rate makes a currency more attractive to hold, and the gap between the rates of two currencies, the differential, is the first thing many analysts look at.

What matters is less the level today than the path expected. If a rise in rates is widely expected, the currency has usually moved before the decision, and the decision itself changes little. A rise smaller than expected can weaken a currency even though rates went up.

The differential is also the source of the carry trade, which holds a higher-yielding currency funded in a lower-yielding one, and of the overnight financing applied to a leveraged currency position. The income from a differential is small beside the movement of an exchange rate, and a fall in the rate can remove a year of it in a day.

A high interest rate is not a sign of strength by itself. Rates are often high because inflation is high, which is the next force.

Inflation is the rate at which money loses its power to buy. A currency that loses purchasing power faster than another tends, over long periods, to fall against it. The idea that exchange rates move towards the level at which the same goods cost the same in both countries is called purchasing power parity.

As a guide to the long run it is reasonable, and as a guide to the next months it is poor: exchange rates stay far from such levels for years.

In the short run the link often runs the other way. A higher inflation figure can lift a currency, because it leads the market to expect the central bank to raise rates. For this reason analysts compare real interest rates, meaning the interest rate less inflation, and not the headline rate alone.

The balance of payments is a country’s account with the rest of the world. Its current account records trade in goods and services, income from investments abroad and transfers. Its financial account records investment flowing in and out.

A country with a current account deficit is buying more from the world than it sells to it, and the difference is covered by money coming in from abroad: foreign purchases of its shares, bonds, companies and property. While that money comes willingly the deficit can last a very long time. If it stops, the usual adjustment is a lower currency.

A surplus is the reverse: a steady source of demand for the currency. Neither is good or bad in itself. A deficit is a dependence, and how much it matters depends on how it is financed and on the mood of the moment.

The terms of trade are the prices of what a country exports compared with the prices of what it imports. When export prices rise against import prices the country earns more for the same goods, and demand for its currency tends to rise with them.

This is why the currencies of countries that export raw materials are often watched alongside the prices of those materials, and why a country that imports its energy can see its currency weaken when energy becomes dear. The link is a tendency. It is strong in some periods and absent in others.

A growing economy tends to attract investment and tends to bring higher interest rates, and both support a currency. Growth is measured by gross domestic product and is watched between its quarterly figures through employment, retail sales and surveys of business.

Growth matters to a currency mostly through the other forces: what it implies for interest rates and what it draws in from abroad. Fast growth that pulls in imports and widens a deficit can sit beside a weaker currency.

At times none of a country’s own figures explains its currency. When investors are fearful they sell what they regard as risky and move into what they regard as safe, and when they are confident they do the reverse. Some currencies have tended to be bought in fearful periods and some sold, largely regardless of that week’s data.

These habits are observations about the past. Which currencies play which part has changed over the decades and is not guaranteed in any one episode.

A central bank sets the short-term interest rate, and it also talks: statements, minutes of meetings, forecasts, speeches and press conferences. Because expected rates matter more than present ones, the words can move a currency as much as a decision.

A tone that leans towards higher rates is called hawkish, and one that leans towards lower rates is called dovish. Readers compare each statement with the last and note what was added and what was taken out.

Each bank has a mandate set in law, usually stable prices and sometimes employment as well, and a published calendar of meetings. Its own publications are the source. A summary of them, this one included, is not.

An economic release is a scheduled publication of a figure. Reading one is a matter of description, and it can be done the same way each time.

• Know what it measures, who publishes it and how often. A monthly survey and a quarterly account are different kinds of evidence.
• Set the figure beside what was expected. The market’s reaction is to the difference, not to the figure.
• Look at the revision to the previous figure. A strong number with a large downward revision to the last one is a mixed report.
• Look inside it. A headline can point one way and its parts another.
• Ask what it changes for the central bank. A figure that does not alter the expected path of rates often moves little.
• Then watch what the price does, and say only that. The same surprise has been followed by different reactions on different days, and the first move in the minutes after a release is often not the one that lasts.