The last 12 months have seen some major movements in economies and stock markets around the world which have all grabbed the headlines. However, the currency markets have been extremely volatile over the last few months as well with economies drifting lower and the attractions of a number of countries around the world diminishing markedly.
Sterling has been one of the major casualties of the last few months against its major partner currencies, the Euro and the Dollar. The value of sterling against these particularly currencies has fallen substantially due to
a number of factors and while there has been some improvement over the last few days there are still serious implications in the short and medium term. But what exactly do the currency markets tell us and what makes them move?
Background into Currency Markets
There are three main factors which move currency markets and they are :-
This is perhaps the more prominent of the three factors we will cover and probably the easiest to read with regards to countries such as the UK. As the UK economy has fallen we have seen the Treasury budget rise as tax receipts are eroded due to the economic slowdown, interest rates remain high as the fight against inflation continues and inflation very strong in the main due to a surge in the oil price.
The increase in the national debt will affect the governments ability to invest into the UK economy in the future and is seen as a weakness because this debt will need to be serviced and eventually paid back. If anything, the higher than expect interest rate, due in the main to the fight against inflation, would normally have supported sterling but other factors have overtaken this impact. A high inflation rate simply erodes the value of the pound in your pocket.
In simple terms, the higher the interest rate for a currency the more income an investor would receive making it more attractive. However, the currency markets fully expect UK base rates to fall at some stage which has seen a flight from sterling to firmer currencies. The balance of trade figures are also very important to the currency markets because the more exports which leave a country the more currency has to be acquired by overseas trading partners – which on a simple supply and demand basis can squeeze the exchange rate higher.
While we may look at the politics in some of the more volatile countries of the world and struggle to understand the impact upon elements such as currency rates, it does have a major affect. The political situation in the UK is also a drag on sterling because there is real speculation of a change in the government when the next general election is called but this is not certain.
The political base for any country in the world is vital because the stronger the base the more focused monetary and economic polices will be. Split governments or low majorities can cause havoc with investment and currency markets because it is like a ship with more than one captain with each one trying to move in a different direction. Over time it will become apparent that investment and currency markets dislike uncertainty, they would rather have good news or bad news, but uncertainty causes confusion.
While the economic and political elements of any country are fairly easy to read if you have the information in front of you, market sentiment is a whole different ball game and can literally change from day to day. Interest rate movements and inflation figures are two of the main elements which will impact on market sentiment but as we have seen over the last few months events such as the demise of Lehman Brothers and the possible collapse of AIG spooked investors and caused ripples to carry right across all investment markets.
The US is a prime example of how market sentiment can move against you in a moment and create what look like small movements in exchange rates, but changes which affect the level of trade both in and out of a country and ultimately the health of the economy. Prior to the recently announced US bailout package there was a growing feeling that the US economy would not suffer as much as many had first predicted, compared to other countries around the world.
However, it soon became apparent that the credit crunch had not run its course with the demise of a number of prominent US companies shocking the markets. This led many currency traders to sell dollars and buy other currencies such as sterling (which had fallen from around £1 – $2 to £1 – $1.78 over the last 18 months). The announcement of the proposed $700 billion bailout was well received in investment markets but the risk factors associated with this move saw more investors bail out of the dollar. A perfect example is the sterling dollar rate which has now rebounded to £1 – $1.85.
Currency Market Prospects
While there are many factors which can and do influence currency markets around the world, at the end of the day an exchange rate, whether it be the sterling dollar rate, the euro sterling rate any other combination of worldwide currencies is a reflection of the strength of one country’s prospects against another – in affect a basic supply and demand scenario. So how can this impact upon overseas property markets?
If we use the example above whereby the sterling dollar rate fell from £1 – $2 to £1 to $1.78 it is easy to see that for example buying a $2,000,000 property in the US would cost you £1,000,000 when the exchange rates was $2, whereas if you bought the same property when the rate was $1.78 to the pound it would cost you £1,123,595 – an increase of over 12%. Alternatively if you had a US property investment and were looking to sell and convert into sterling you would receive a better deal when the rate was lower as you would get more pounds to the dollar.
Many people assume that there is no currency risk with overseas property investment but this is simply not true. The risks can be greater if you are dealing in developing or emerging markets where currencies can and do fluctuate markedly. As well as the prospects for the property you are looking at you also need to compare the prospects of the country against your home country (and home currency) and take these into account.