Currencies: what is ahead?

In particular, the values of the British pound (GBP/USD) and the Japanese yen (USD/JPY) have fluctuated sharply against the US dollar. The movements of the euro (EUR/USD) have also been significant this year, although not as strong as the other two mentioned.

Fluctuations in currency pairs can be traded on the Finnish stock exchange with Vontobel's leveraged products, which offer opportunities to seek returns with GBP/USD and EUR/USD currency pairs.

The US dollar has been the winner of this year's currencies, its value has risen against practically all currencies as the threat of recession prevails around the world.

The British pound's collapse against the dollar from last year's spring levels of over 1.40 to almost parity has been epic. Since then, the pound seems to have found a local bottom, but this currency pair will potentially offer the volatility that traders are looking for in the future as well. GBP/USD is currently trading around the 1.13 level.

In addition to general uncertainty, the GBP/USD currency pair has recently been rocked by Prime Minister Liz Truss's inauguration and subsequent quick resignation after only 44 days. A successor to Truss has yet to be decided, but the new appointment could potentially continue to affect the value of the pound against the dollar.

In recent weeks, EUR/USD has traded at or below parity for the first time since 2002. The euro is particularly weighed down by concerns about economic growth as the region prepares for a difficult winter as the energy crisis threatens the whole of Europe.

The volatility of the market is hardly over by this point, and as the world's largest financial market, currencies will also offer opportunities for the pursuit of returns.

So what factors affect the fluctuations of currency pairs? The following is a list of the most significant factors:

1. Differences in inflation

A consistently lower inflation level typically correlates with a rising currency value. When inflation is low, the purchasing power of the currency is higher. Countries with high inflation typically experience currency depreciation relative to other countries' currencies. High inflation is normally followed by higher interest rates. If the government's inflation level is not particularly high, a slight rise in inflation can give clues about the central bank's future rate hikes, as we have seen this year when central banks around the world are fighting rising inflation. Rising interest rates make domestic stocks and bonds more attractive to foreign investors. In order for investors to buy them, they must acquire more of that currency, and according to the laws of supply and demand, the value of that currency will rise.

Rule of thumb: if Britain's inflation level is consistently lower than the US, GBP/USD will rise, unless in a mild inflationary environment the rise in US inflation indicates future interest rate hikes by the FED.

2. Differences in interest rates

When making decisions on interest rates, central banks indirectly affect both inflation and the currency market, and changing interest rates affect inflation and currency values. Higher interest rates offer lenders higher returns compared to other countries. As a result, higher interest rates attract foreign capital and the domestic currency strengthens. However, the effect of higher interest rates is mitigated if inflation in the country is much higher than in other countries. The opposite relationship holds with falling interest rates – in other words, lower interest rates weaken the currency.

Rule of thumb: GBPUSD rises when UK interest rates rise more than US interest rates (eg the Bank of England raises rates and the FED doesn't).

3. Current account balance

The current account is the trade balance between a country and its trading partners, which includes all payments for goods, services, interest and dividends. A deficit means that the country spends more than it earns and borrows capital from abroad. The country needs more foreign currency than it gets from exports, and it supplies more of its own currency than foreigners demand for its products. Excess demand for foreign currency lowers the country's exchange rate.

Rule of thumb: EURUSD rises when the current account balance between the euro area and the US increases for the euro area.

4. Sustainability of public finances

Countries with large deficits and high levels of debt are less attractive to foreign investors. A high level of debt leads to high inflation, and if inflation is high, the debt is serviced and eventually paid off with a weakened real currency. The government can "monetize" some of its large debt burden, but increasing the money supply will inevitably cause inflation. In addition to this, if the government is unable to manage its deficit through domestic means (by selling domestic bonds, increasing the money supply), it must increase the supply of securities sold to foreign investors, which lowers their prices. Finally, a large debt burden can be a worrying sign for foreign investors if they believe a country is at risk of defaulting on its obligations. Foreigners are less willing to own securities denominated in that currency if the risk of default is high. For this reason, a country's credit rating is a determining factor in its exchange rate.

Rule of thumb: GBP/USD rises when the US public deficit/debt increases more than the UK deficit/debt.

5. Growth

Economic growth is always the best variable for measuring economic well-being. Investors are attracted to countries with high GDP growth, as this indicates higher future returns. Investors need more currency to buy goods, services and securities, resulting in an increase in demand for that currency.

Rule of thumb: EUR/USD rises when the GDP of the Eurozone grows more than the GDP of the USA.

6. Labor market conditions

The health of the labor market is another variable for measuring the well-being of the economy, as it is positively correlated with the GDP growth rate. The unemployment rate, the wage level and the number of unemployment benefits are the best indicators for assessing labor market conditions, and investors tend to invest their money in countries with low unemployment rates.

Rule of thumb: GBP/USD rises when the UK unemployment rate is lower than the US.

If you believe the pound will strengthen against the dollar, you can aim for returns with Vontobel's TLNG GBUS V9-Turbo, which at the time of writing offers 7,5x leverage. If the pound strengthens by a percentage equal to the dollar, Turbo's value will increase by 7,5 percent. If, on the other hand, the pound depreciates by one percent, the Turbo produces a loss of 7,5 percent.

If your view is a weakening of the euro against the dollar, you can trade the TSRT EUUS V78-Turbo launched by Vontobel. At the time of writing, its leverage is 11,8. If the euro weakens against the dollar by one percent, Turbo generates 11,8 percent profit. If, contrary to expectations, the euro rises by one percent, the loss of the Turbo position will be 11,8 percent.