Exchange rate volatility – watching you watching me

news: Exchange rate volatility – watching you watching me

IT’S ALWAYS the activity in your peripheral vision that makes the difference. A resident in the Algarve, moving funds from the UK for further property investment, might not even be aware of what is happening in Germany when deciding when to buy their Euros, but that is exactly what is giving the GBPEUR exchange rate a boost at the time of writing.

The confusion over whether the tiny advantage that Angela Merkel’s Christian Democrats achieved will enable her to form a coalition government, and whether that coalition will allow her to undertake the reforms she proposed has created uncertainty in the financial markets. And, if there is anything guaranteed to weaken a currency, it is political uncertainty.

You may also have seen the resurgence in the Japanese economy out of the corner of your eye. Having swept to a landslide victory, PM Koizumi has a mandate to make strident reforms of the structure of Japanese business, to modernise the economy and to rediscover the economic miracle that Japan became in the 30 years following the Second World War. The markets are fully behind his plans and the Yen has attracted a lot of overseas investment as a direct result. As it turns out, perhaps too much investment and the dampening of some of that enthusiasm allowed the Yen to weaken again.

This volatility in the value of the Yen would appear to be totally unrelated to the GBPEUR exchange rate. However, funds flowing from Japan found their way into the US financial markets as evidenced by the $87.4 billion of inward investment America reported in August. The weaker Yen has produced a stronger US Dollar and Dollar strength will tend to weaken the Euro. Very often, a factor that appears to be far away and unrelated can sneak up and disarm you before you know it.

So, at the moment, the external factors are benefiting those with Euros to buy, but what of those of you with Euros to convert to Sterling to take funds back to the UK? Well, your day will come, but it is looking as though you may have a long wait.

This bout of Euro weakness is certainly exacerbated by the stronger US economic position, which hasn’t been too badly hit by the effects of Hurricane Katrina. Euro weakness also comes from the fact that Eurozone interest rates have remained at two per cent for 26 months, while UK and US rates have risen significantly. This has created an environment where international investors are lured by the 4.5 per cent in the UK and 3.5 per cent in the US. And, what’s more, US rates are due to be raised to 3.75 per cent on September 20 (it should have happened by the time you read this), adding stimulus to the westward flow of funds across the Atlantic.

Economically, the Eurozone presents so many dilemmas for the European Central Bank (ECB) – no wonder they have chosen the path of least resistance and sat on their hands for over two years. Germany and Portugal are desperate for lower interest rates to help to stimulate the economies, but the ECB can’t cut the base rate for fear of over stimulating consumer spending in Ireland and Spain, and for fear of adding weight to the clamour in Italy to withdraw from the Euro project altogether. Many Italians are very vocal in their demands to have their beloved Lira back and, in some areas, contrary to the Eurozone regulations, shops display both Euro and Lira price tags in the hope that Italy will one day extract itself from the Euro and life can return to normal.

It isn’t an immediate worry for the ECB, but the Euro will always be susceptible to rumour and speculation and the ECB will do what it can to avoid any of these becoming a reality.

And that’s the thing with the foreign exchange market. The ECB is watching the Italians, who are watching the Germans, who are watching the Americans, who are watching the Japanese. Meanwhile, we are watching all of them, waiting for an opportunity for our clients to gain on the rate, whether they are buying or selling.