How currencies are priced: rates, trade and risk

A currency is the one asset whose price is always quoted against another. There is no absolute value for the euro or the yen, only a rate against something else, which means every currency move is really a statement about two economies at once.

Economists have proposed several frameworks for exchange rates. None works on its own, but together they cover the main forces, and knowing which is dominant at a given time is what makes a currency move intelligible.

Interest rates

Over horizons of weeks to months, the single most important driver of a major currency is the gap between its interest rates and those elsewhere, and more precisely the expected path of that gap. Money moves toward higher returns. If a central bank is expected to raise rates while another holds, the first currency tends to strengthen, even before the increase happens.

Expectations matter more than levels. A currency with high rates can fall if the market comes to expect cuts, and a currency with low rates can rise if the market anticipates increases. This is why currency markets react so sharply to central bank communication and to data that changes the expected path.

Forward exchange rates, at which currencies can be exchanged for delivery in the future, are set mechanically by the interest-rate differential rather than by any forecast. A currency with higher interest rates trades at a discount in the forward market. This is an arbitrage condition, not a prediction.

Trade and capital flows

A country that exports more than it imports receives more foreign currency than it pays out, which supports its currency; a persistent deficit does the reverse. In practice, trade flows are dwarfed by financial flows, and a country running a trade deficit can sustain a strong currency for years if foreign investors want to buy its assets.

The current account, which includes trade plus investment income and transfers, is the broadest measure. Economists use it, along with measures of relative prices such as purchasing power parity, to estimate a long-run fair value for a currency. Those estimates are useful for spotting large misalignments but say almost nothing about where a currency will trade next month.

Risk and safety

In periods of stress, capital moves toward assets and currencies perceived as safe, regardless of interest rates or trade. The dollar, the Swiss franc and the yen have historically played that role, each for different reasons: the dollar because of the depth of dollar markets and the amount of global borrowing denominated in it, the franc because of Switzerland's financial stability, the yen because Japanese investors repatriate money in a crisis.

Currencies of commodity exporters and emerging economies tend to move in the other direction, weakening when risk appetite falls. This pattern means that a currency move can reflect global sentiment rather than anything specific to the country involved.

Intervention and policy

Governments and central banks sometimes act directly, buying or selling their own currency to influence its level. Intervention is more common in emerging markets and in economies with managed exchange rates. Among major currencies it is rare and usually aimed at slowing a move rather than reversing it. Capital controls, which restrict the movement of money across borders, are a stronger tool and are used mainly by countries with less open financial systems.

Reading a move

When a currency moves, ask three questions. Have rate expectations changed, either at home or abroad. Has risk appetite shifted globally. Has anything changed in the flow of money into or out of the country's assets. Most moves in major currencies can be traced to the first or second; the third tends to work more slowly.

This guide is general information, not investment advice.