Written by 1:30 pm abroaden weekly insights

Why exchange rates are so insanely crazy right now.

exchange_rates_insane

This is a re-post of our 11th issue of our “WTF is going on with the Economy?” newsletter which talks about exchange rates. You can read the original here. Get future issues delivered directly to your inbox. Sign up here.

If there’s one piece of the economy we all know, it’s currency. 

That should come as no surprise: the economy runs on money. 

Every day there are more than 5 trillion US dollars worth of currencies traded in forex or “FX” markets around the world. These transactions power global trade and keep the economy running. 

Yet, for its size, most people barely know currency markets exist.

Except you’re not most people: you’re an expat. Or a digital nomad. Or a remote worker. Or even someone who loves to travel internationally or live abroad.

For many of us, dealing with different currencies is a fact of life. Our clients (and income) come from far-flung corners of the globe. 

We work remotely for companies in different time zones and climates. Our nest egg sits in a bank account across an ocean. 

In other words, exchange rates are always sitting in the back corner of our minds. 

So chances are you’ve noticed that these rates have been more active than a volcano over the last few weeks. 

Here’s why exchange rates were so crazy. 

First, let’s quickly go over how exchange rates work. 

Each country or currency region (like the Eurozone) has a central bank. 

Their main jobs are to manage growth and inflation plus ensuring there’s enough cash available to keep the economy going.

To do so, they have two tools at their disposal: 

  • Setting interest rates for borrowing
  • creating and destroying money

The interest rate, in particular, speaks volumes about the health of an economy. It determines the benchmark rate for loans, savings accounts, and mortgages. This amount varies from country to country, with some nations having higher ones than others.

The difference in interest rates between the two economies forms the foundation of the exchange rate.

In addition to interest rates, there are other factors at play that impact FX markets.

Global investors invest, well, globally. Nothing is stopping a trader in Tokyo from buying and selling shares on Wall Street or in London. To do so, she needs to convert her Japanese yen to US dollars and British pounds.

Of course, she lives in Japan, where she shops, eats, and parties with yen. When she sells her foreign investments, she’ll also need to convert back her greenbacks and sterling. 

Get the latest from WTF is going on with the Economy?!
right when we publish

These types of transactions occur all the time and go well beyond stock trading. Most global commodities like gold and oil set their prices in US dollars. As international traders either speculate or purchase these assets, they must eventually exchange currencies to get their money back ‘home.’ 

Throw in the enormous bond (loan) markets plus global trade, and it’s clear why exchange rates are always moving.

Finally, central banks aren’t the only policymakers controlling vast sums of cash. Politicians approve spending programs or tax cuts, putting money directly into their economies. These plans (should) grow the economy and impact the FX rate. 

Consequently, when there’s lots of growth, central banks try to keep it in control, using their tool kit. The whole process is cyclical, with currency markets joyfully(?) going along for the ride.

We wrote about how exchange rates and currency trading works on our blog. It goes into more detail than I can do so here, so check it out if you’re interested. Also, there’s a gif of a cat and dog in a hot tub in there, so you probably don’t want to miss it.

In any case, it’s all circular and dynamic. 

When the global economy is calm, the daily changes are small. When the economy is volatile and uncertain, currency markets follow… 

…Which brings us to mid-2020.

Let’s break down what’s happened.

The economy began to show real signs of weakness in late February and early March. At the time, investor panic was spreading faster than the virus. People and companies were desperate for cash and were selling practically all of their investments. 

With everyone and their mother demanding cash, there simply wasn’t enough to go around. Central bankers went into overdrive. They cut interest rates to get money out of deposit accounts and into their economies. 

More dramatically, central banks told investors that they would buy their government and corporate bonds, no questions asked. This policy continued as the crisis spiraled out of control, with trillions of dollars flooding the economy. 

Currency markets reacted sharply to the near-hourly news coming from the central banks, inflaming already unstable exchange rates. 

Next, governments the world-over opened up their wallets, desperate to avoid economic catastrophe. Each big spending plan varied in size and effectiveness, with the overriding theme of circumventing a depression. 

Still nervous and in search of gains, stock market investors scoured the globe for profit opportunities. As the outlook changed daily, they rapidly moved their money across borders. These continuous spikes in demand for various currencies added even more volatility to FX markets. 

The result? Exchange rates dropped and climbed more in one day than they would in a month during normal times. 

Last week was probably the best example of this system in action.

In Europe, two significant events happened.

First, the European Central Bank said they were going to continue buying bonds from investors to keep the money flowing. 

That announcement was expected. What caught everyone off guard was the amount — 600 billion euros worth — which was much higher than anyone expected. 

Second, the German government unveiled a mammoth recovery program. At the same time, EU leaders agreed to a spending package to help hard-hit countries in the south. Combined with the lockdowns ending, investors saw a massive opportunity in Europe. The demand for euros skyrocketed. By Friday, the common currency completed its biggest weekly gain in nine years. 

Crazy, right? 

If you’re sitting at home wondering about all of this, here’s what you can do.

For one, don’t lose any sleep over exchange rates. There is absolutely nothing you can do to control them. 

Second, if you need to exchange money to eat and pay your bills, be wary about trying to play the market. It’s volatile out there, and again, exchange rates can literally only go two ways: up or down. Only take risks that you’re comfortable with (see the part about not losing sleep). 

Right now, a lot is going on across the globe. Exchange rates are just one of many moving pieces. Swings like this come during periods of mass uncertainty. There’s no rule saying that FX markets will somehow calm down or ramp up; it’s really a reaction to the unknown. 

For now, we can just go with it. After all, it’s only a small part of the show. 

Abroaden is a company for expats, digital nomads and other world citizens looking for low-cost and transparent financial advice and investment management.

get the #1 economics newsletter for people living abroad

Take the guesswork about understanding the economy while living abroad.

Thousands of expats, remote workers, and digital nomads read our newsletter each week; empowering them to make sense of the world and better financial decisions.

Please wait...

Thanks for signing up!