Exchange rates are notoriously difficult to predict. One key reason is that currency movements can be influenced by myriad economic, financial and political developments that are themselves hard to anticipate. And yet their effect on exchange rates cannot be overstated. For instance, sudden political turbulence can mean that the widely anticipated appreciation of a currency is replaced by a sharp fall. Similarly, an unforeseen collapse in oil prices may mean that the currency of an oil-exporting country weakens, while that of an oil importer gains ground.
However, that is not the end of the story: Even without the proverbial crystal ball, investors tend to form views about how the global economy is likely to develop or how a political situation might play out – and they use those assumptions to form a picture of possible currency movements. Investors may anticipate that oil prices will rise sharply, that the US term structure will flatten or that a recent increase in the CBOE Volatility Index (VIX) will be only temporary – and they are interested to know how such events will affect exchange rates. And the fact is: Forecasting exchange rates based on these ‘risk factors’ is much easier than traditional forms of forecasting that make no assumptions about future economic and financial conditions.
This issue of Infocus looks at how a series of risk factors can impact on the bilateral exchange rates of 36 currencies to the US dollar – ranging from the Argentine peso to the Hungarian forint and the Japanese yen to the Turkish lira. The risk factors analysed include the spread between Moody’s Baa-Aaa corporate bond yields, oil prices in US dollars, the price of non-oil commodities in US dollars, and the performance of the VIX.
The study reveals that exchange rates tend to react in systematic ways to economic developments in both the US and global economies. These reactions are often predictable – e.g. with the Japanese yen and Swiss franc both appreciating against the US dollar when the VIX rises, or the Russian rouble strengthening if oil prices soar. That said, other foreign exchange impacts are perhaps less obvious – with emerging markets currencies generally appreciating and developed market exchange rates generally depreciating against the US dollar as economic conditions improve.
While the findings of the study cannot be used directly for portfolio allocation, knowledge about how exchange rates are likely to respond to different risk factors can be helpful for investors seeking to prevent an excessive accumulation of risk in their portfolios.
Download the full edition of our InFocus publication here
