Share investors need to have an understanding of exchange rates because they will influence stock prices. Companies with overseas operations may be impacted positively or negatively depending on the direction on the exchange rates. Not only that, but exchange rates can influence the amount of overseas funds being invested in Australian shares. This article describes the 7 major causes of exchange rate movements. We have also discussed the effects of exchange rates on stocks in a previous  article on stocks to buy with a lower dollar.

The 7 key factors that affect exchange rates:

– Inflation

– Interest rates

– Speculation

– A Country’s Trade Account

– Political Stablility

– Economic Environment

– Government Debt

1.Inflation

Countries with low inflation rates will have stronger exchange rates than countries with high inflation. If inflation is too high, then goods become more expensive for domestic consumers as well as overseas buyers. Importers will look for other countries where goods are cheaper. This will make countries with high inflation less competitive. This in effect reduces the demand of products as well as the demand for the currency.

2.Interest Rates

High interest rates may cause an appreciation of the currency whereas low interest rates may cause depreciation. Investors will look to put their money in countries which have high interest rates as they can get a better return. For example, if Australian interest rates are higher than other countries then investors will want to deposit money in Australia. This in turn will increase the demand for the currency and increase the exchange rate.

3.Speculation

Similarly, to the stock market, currency rates are based on demand and supply. Speculators buy currencies now in the hope it will appreciate and then sell at a profit in the future. If there are many investors who hold this view then this will drive up demand and it will increase the exchange rate. Sometimes the exchange rate movements are influenced by market sentiment as opposed to economic fundamentals.

4.Country’s Trade Account

The country’s trade account is the how much a country imports in comparison to how much that country exports. A trade deficit means the value of imports is greater than the value of exports. A trade surplus means the value of exports is greater than the value of the imports. When a trade deficit occurs, the country’s demand for foreign goods is higher than local goods so there is less demand for the local currency. This in effect decreases the value of the currency rate. A trade surplus means higher demand for the local currency and a stronger currency rate.

5.Political stability

Investors will have more confidence in a currency where there is political stability. There will be a higher demand for a country’s currency if investors feel their funds are invested in a safe and stable environment. If there is political instability there will be less demand for that currency and this may cause a depreciation in exchange rates.

6.Economic Environment

Interest rates are correlated to the economic health of a country. When there is a recession, interest rates tend to be low to stimulate the economy and generate growth. However lower interest rates discourage foreign investment demand which depreciates the currency. When the economy is strong and interest rates are high, then there is an increase in demand for that currency.

7.Government Debt

If a country has high national debt and the market cannot see how this debt can be paid back then investors may sell their bonds. This could in turn lead to a devaluation in the currency. However, if a country has low debt then it will be perceived as a safe and stable currency. This will therefore increase the demand of the currency.

Lauren Hua is a private client adviser at Fairmont Equities.

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