What drives currencies?

Currency forecasting is never an easy thing to do. The drivers of currencies appear to change over time making it quite tough to develop forecasting tools with great accuracy. This is not an excuse from someone who has been trying to analyse currencies for a number of years but just a statement of reality. Over the past year or so one of the biggest drivers of currencies has been risk appetite. As equity markets sank in 2008 the main winners were the dollar and yen both of which appreciated due to strong repatriation flows and safe haven demand. This influence of risk in determining currency movements saw historical influences such as interest rate differentials pushed into the background.

Where does it leave FX now? Well, if the rally in equity markets continues it implies that both the dollar and yen will fall further whilst long suffering currencies such as the pound will strengthen further. In the pound’s case it has a lot of room to recover given that is massively undervalued by many measures. For instance during my time in Hong Kong the pound against the dollar has dropped by around 30% making things look far more expensive than when I first came. However, to a foreigner UK assets now look quite well priced and London is no longer such an expensive city. Add in the steep drop in house prices and the UK looks even more competitive. This will no doubt benefit the economy in time.

So if the current risk/FX relationship holds it means that we should all be watching equity markets to see where currencies are going to move over coming months. If equity markets fail to sustain their rally it could put the dollar back on the front foot which will see the pound back under pressure. Eventually the dollar will weaken as risk appetite improves and when that happens the pound may be one of the main beneficiaries.

Ps. I hope this works as I am posting this article on holiday. It also means that my contributions may be a bit more sporadic over the next couple of weeks.


4 Responses to “What drives currencies?”

  1. How compelling are equity valuations? « ECONOMETER Says:

    […] How compelling are equity valuations? Relief over the results of the US bank stress tests, better than expected US jobs data, generally less negative economic data in general, as well as better than expected Q1 earnings provided markets with plenty of fuel over recent days and weeks. This has helped to spur an improvement in risk appetite and a resultant strengthening in equity markets. Meanwhile, government bonds have sold off, commodity prices have risen and the USD has weakened. […]

  2. US dollar under pressure « ECONOMETER Says:

    […] I noted in a previous post, “What drives currencies?” risk appetite has been one of the biggest drivers of currencies in the past year.   This has […]

  3. Are currency market dynamics shifting? « ECONOMETER Says:

    […] that it has come at a time when risk appetite has continued to improve, suggesting that the strong risk appetite/dollar relationship that has been in place for much of the past year could be diminishing in strength.  For instance, […]

  4. Risk trades under pressure « ECONOMETER Says:

    […] surveys an interest rate decision in Japan, and inflation data in various countries, the main direction for currencies will come from equity markets and Q2 earnings […]

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