In the decade prior to the 'credit-crunch', foreign exchange markets were simpler than today. Certain key factors influenced markets in a logical and rational manner, and king of all these factors was interest rates. Interest rates represent the price of money - they are the rate of return for holding a currency and the price of borrowing it. Historically, a cut in interest rates would tend to lead to a fall in a currency's value, and vice versa. Money flowed from currencies where the cost of borrowing was relatively cheap (e.g. Japan), to currencies where the return (interest rate) was relatively high (e.g. Australia), in what was known as the 'carry-trade'.
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However, in recent times central banks have tried to stimulate economies by slashing interest rates to record lows: US 0-0.25%; UK 0.5%; Japan 0.1%; Switzerland 0.25% and the Euro zone 1% (at the time of writing). This has levelled the playing field, and caused other factors to become more important for exchange rates. These include signs that an economy might recover more quickly than its peers, levels of government debt, and the cost/effectiveness of unconventional measures such as 'quantitative easing' (increasing the money supply).
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The key theme in 2009 has been risk-aversion. Currencies perceived to carry a greater degree of risk (emerging market currencies, and the high-yielding antipodean Dollars) have been shunned in favour of the perceived "safe-havens" (Yen, Swiss Franc, and most importantly the US Dollar). This explains, for the most part, the Dollar's irresistible rise throughout this crisis. Another key determinant has been the credibility of economic policy - The US Federal Reserve, and to an extent, the US government are perceived to have got to grips with the situation more quickly than other countries' monetary and political authorities. The fast, decisive actions taken pleased the foreign exchange markets, and as a result the Dollar benefited. Sterling, on the other hand, has been hit by the market's negative perception of the UK's fiscal policy, especially the spiralling budget deficit.
So what does this new world order mean for Sterling? Most believe that UK interest rates are likely to remain near zero for some time, and that inflation won't rear its ugly head, in the short-term at least. Markets determine the value of currencies via a mixture of economic fundamentals and sentiment. In a system of floating exchange rates, currencies react to economic variables, adjusting to imbalances in trade flows and productivity and thus bringing relative prices into line.
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Sterling has recovered a little in 2009; indeed it currently stands more than 8% away from its low against the Euro, and nearly 12% off its low against the US Dollar. Many analysts believe that Sterling is undervalued based on a range of economic factors. However, sentiment towards Sterling needs to improve before these factors can produce a meaningful recovery. Sometimes, it takes an 'event' to trigger this - in the case of Sterling versus Euro, this could be as simple as a sudden improvement in UK data, though we suspect that problems in the Euro zone might ultimately prove to be the catalyst. With different member states being hit by the downturn to differing degrees, the difficulties faced by the European Central Bank (ECB) in setting a "one-size-fits-all" monetary policy could become more apparent. Additionally, the internal strains caused by some members' failure to stay within the economic boundaries set for the Euro could further destabilise the Euro zone. In the case of the US Dollar, Sterling's recovery could be more gradual, the greenback sliding as risk appetite improves.
Until the situation becomes clearer, we expect foreign exchange markets to remain volatile. It has never been more important to make the most of your Sterling, and keep abreast of market developments. The MSN Currency Service aims to offer the best exchange rates, the best service, and the best informtion.
