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12 Aug 2021

Understanding foreign exchange and why currencies move up and down

By Damon Frith, content editor for Citi How to save money on foreign exchange.

Whether it's for work, leisure or family we all find ourselves dealing with foreign currencies at some point. By understanding why currencies change in value you will be able to better determine when to buy or sell currencies, and that knowledge can save you thousands of dollars.

The strength or weakness of a country's currency tends to reflect the economic health of the nation. It’s like a barometer.

By understanding the barometer of our own country and another you want to visit, you can be better prepared to decide when is the best time to make a currency conversion before you travel, send money overseas to family or make an offshore investment or retail purchase.

    What moves the barometer's needle?

    Countries with high employment and wage growth likely have strong consumer populations. When populations spend it boosts company profits and increases government revenue from taxes. It all adds up to strong economic growth.

    Investors, both individuals and institutions, and even other governments notice that prosperity and look for options to invest. This activity pushes the target currency higher. Of course, the currency will weaken if unemployment is rising, government revenue falling, and investors are shifting funds to other countries.

    Australia also gets a boost as it is one of only eight countries in the world with the highest AAA credit rating. The ratings are determined by global credit agencies like Moody's and Standard & Poor, and it gives an indication of the risk associated with buying a nation's sovereign debt, better known as government bonds. It's another strength behind the dollar.

    Safe haven currencies

    Even the United States of America does not have as high a credit rating but it has other advantages. The US dollar is both the currency of choice for international trade and a safe-haven currency. The latter means there is confidence the nation’s treasury will continue to honour government debt even in dire times. Other safe haven currencies include the Swiss Franc, Euro and Japanese Yen.

    Commodity currencies

    Australia is known as a commodity currency due to its dependence on the export of minerals, gas, agriculture and bulk commodities like iron ore, bauxite and coal. Other commodity currencies include New Zealand and Canada.

    It has a real impact on the movement of our dollar, and its why during the Chinese-demand fuelled commodities boom between 2003 to 2011 the Australian dollar rose strongly against the US dollar. For a time it was even worth more than the US dollar.

    The outlook for commodities this year has improved as manufacturers seek to replenish stock and governments spend on infrastructure to boost their domestic economies and create jobs. This helped support and push higher the Australian dollar in the first half of this year.

    In recent months, China's economy has slowed down, as has its appetite for commodities. The US has also pared back it's government infrastructure spend plans. These measures have led to a fall in commodity prices, and also the Australian dollar.

    Also working against the Australian dollar is the strength of the US dollar and an expectation the US will raise interest rates well before Australia does. The Reserve Bank of Australia has said repeatedly this year it does not expect interest rates to rise until 2024. In comparison, the market expects the US Federal Reserve to start raising rates late next year. 

    The issue here is that a higher US interest rate regime would attract a greater share of global investment spend, while funds would flow out of Australia as it would not offer as attractive returns, and this would weaken the dollar.

    AS of July 12, the dollar is trading under US74c, which is below our expected trading range between US76c-US78c forecast for the second half of the year. However, we expect there to be spikes and troughs that take it out of the range for a period, and these can offer opportunities to buy or sell currency, depending on your needs.

    Currencies move not just on what's happening within a local economy but how that economy fits into the regional and global picture. So when considering how a currency may move its important to take an international perspective.

    High impacts on the Australian dollar

    • Commodity prices 
    • Economic Outlook     
    • Performance of US dollar

     

    Perception is everything

    How investors perceive a country is an important driver for its currency. Australian's likely think of our country as having an active and vibrant tourism industry, and it does.

    But international investors do not perceive it as a prime driver of the economy, so impacts of COVID-19 on tourism did not have a major impact on the dollar.

    On the other hand, the economy of Thailand is heavily dependent on tourism, and as the virus spread its currency (Thailand baht) weakened. As international borders start to re-open it will put strength underneath Thailand's currency. 

    You don't need to be an economist to look for the big drivers that may be impacting a currency, some simple research should be sufficient. 

    Armed with this knowledge, you can make more informed decisions about managing currencies, determine when it's time to get professional advice for more significant decisions like an offshore investment, or when to purchase another currency in preparation for future travel plans.

     

    Wealth Solutions

    This document is distributed in Australia by Citigroup Pty Limited ABN 88 004 325 080, AFSL No. 238098, Australian credit licence 238098. Any advice is general advice only. It was prepared without taking into account your objectives, financial situation, or needs. Before acting on this advice you should consider if it's appropriate for your particular circumstances. You should also obtain and consider the relevant Product Disclosure Statement and terms and conditions before you make a decision about any financial product, and consider if it’s suitable for your objectives, financial situation, or needs. Investors are advised to obtain independent legal, financial, and taxation advice prior to investing. Past performance is not an indicator of future performance.