Most people only think about exchange rates when they’re about to go on holiday.
But changes in a currency’s value have far-reaching implications that stretch beyond the cost of travel. They can affect investing, job creation, the rate of inflation and the value of your savings.
In June 2016, the pound fell abruptly, by around 10%, immediately after the result of the UK’s referendum on membership of the EU: one of the more graphic demonstrations of how a currency’s value is vulnerable to external influences.
But there are winners and losers whatever direction the currency takes. Here we run through the factors dictating a currency’s value, and who benefits from a strong or weak pound.
What affects a currency’s value?
Money is traded on international foreign exchange markets by speculators and investors, and as in any market, an asset’s value is determined by the laws of supply and demand. In this context, countries’ interest rates are arguably the most influential factor in driving demand.
This is because international investors are looking for good returns on their money.
If the UK’s interest rate is higher than in other countries, the returns on investments, such as UK bonds and gilts, will be attractive in comparison. That means there is a strong correlation between the Bank of England base rate and the returns paid on various investment products.
Investors must buy UK assets with pounds. As more investors buy more pounds to buy these assets, demand increases, and the value of sterling rises in turn.
UK economic strength
Currency investors like to invest in solid, growing economies, since the value of the currency will be more stable than in smaller, less established markets. However, this also increases the allure of relatively high or rising interest rates, since rates are most likely to rise when an economy is expanding.
Earlier in the year, the Bank of England was the only major central bank in the world to be talking about hiking rates. That helped the pound surge in the first half of 2019. Indeed, for much of the year it was the best-performing currency among developed economies.
More recently, however, political deadlock and the increasing likelihood of a no-deal Brexit have sent currency markets reeling, and the pound recently hit a two-year low.
It is not all bad news, though.
A weaker pound is good news for UK exporters, because their goods become cheaper to overseas buyers – which is also beneficial to the domestic hospitality industry.
Also, investors may well have noticed that when the pound weakens, the FTSE100 index tends to rise. This is because around 70% of the FTSE100’s revenues come from overseas, with a large proportion of that denominated in US dollars.
When the pound falls in value, those dollar earnings buy more pounds when exchanged back into sterling, making those revenues more valuable.
However, a weak pound is damaging for UK importers and manufacturers with supply chains overseas as the purchasing power of their pounds is reduced.
It also tends to push up inflation, as the UK imports more than it exports. So, a weaker pound will make goods more expensive for both companies and consumers
Anyone on a fixed income, like many pensioners or workers who have not had a pay rise in several years, will be hit hard because inflation will eat into the purchasing power of their income, effectively making them poorer.
Under some Brexit scenarios, a rate cut could be as likely as a hike; as we have seen, the ramifications of either will be impactful and wide-ranging.
However, whether or not currency volatility is driven by economic or political considerations, it is possible to literally price it into investment decisions. The ever-shifting situation creates opportunities for savvy investors: opportunities the investment managers at Brewin Dolphin are seasoned at spotting and incorporating into their investment strategies.
The value of investments can fall and you may get back less than you invested.
Past performance is not a guide to future performance.
The information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness.
If you invest in currencies other than your own, fluctuations in currency value will mean that the value of your investment will move independently of the underlying asset.