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How to predict future exchange rates

Predicting currency rates is a challenging endeavour due to the dynamic and complex nature of the global financial markets.

Accurate forecasts are difficult to achieve, yet they are crucial for investors, businesses, and policymakers alike.

So, how do they make their best attempt?

In this article, we’ll look at the various timeframes used to categorise predictions, along with the factors that impact currency rates, including which ones we think are the most important.

We’ll also consider hedging products and whether they’re a safer strategy for managing your currency risk.

Sensible prediction timeframes

Generally speaking, predicting currency rates in the mid to long term is more reliable than short-term forecasts.

Short-term predictions, often sought after by forex traders, are highly susceptible to market volatility, frequently leading to inaccuracies and potential financial losses.

In contrast, mid to long-term predictions allow for a more comprehensive analysis of economic trends and policy impacts, offering a more stable basis for forecasting.

Factors impacting currency rates

Economic Indicators

Economic indicators like interest rates, inflation, and GDP growth play a significant role in determining the strength of a currency. These indicators reflect the economic health of a country, influencing investor confidence and currency value.

Political Stability

The political environment of a country can significantly impact its currency value. Stable governance tends to strengthen a currency, whereas political turmoil often leads to depreciation.

Market Sentiment

Market sentiment, driven by traders’ perceptions and expectations, can cause immediate but often short-lived fluctuations in currency rates.

Trade Balances

A country’s trade balance, i.e. the difference between its exports and imports, directly influences the demand for its currency and, consequently, its value.

What are the most important factors?

When we say ‘most important’ we’re referring to those that provide a more consistent and measurable impact on currency values.

Market sentiment and trade balances are considered more volatile as they are of a subjective nature.

Conversely, economic indicators and political stability are often the most influential in currency rate prediction.

So, let’s dive into the various economic factors in a bit more detail.

In-Depth – Economic Factors Impacting Currency rates:

Interest Rates: Central banks manipulate interest rates to control economic growth and inflation. Higher interest rates in an economy of interest, offers lenders a higher return relative to other countries.

As a result, higher interest rates attract foreign capital, increasing the demand for the domestic currency.

For instance, if the U.S. Federal Reserve raises interest rates, the value of the U.S. dollar typically increases as investors seek higher returns on dollar-denominated assets.

Inflation: Inflation is the rate at which the general level of prices for goods and services in an economy rises over time.

Inflation erodes purchasing power because as it increases, the same amount of money buys you fewer goods or services, which can lead to currency depreciation.

Conversely, countries with lower inflation rates are more attractive to investors and traders because the lower inflation preserves their purchasing power…Inflation is used as a key predictor for FX rates as countries with lower inflation rates will often see their currency value rise compared to those experiencing higher inflation.

For example, if the Eurozone has a lower inflation rate than the United States, the value of the euro is likely to increase relative to the U.S. dollar.

Gross Domestic Product (GDP) Growth: GDP is a comprehensive measure of a country’s economic activity.

GDP growth is seen as a key indicator for a country’s economic health. Strong GDP growth positively influences investor perception, as it suggests a robust economy and profitable investment opportunities.

This, in turn, increases demand for the country’s currency. For example, if India reports higher GDP growth, it may lead to an appreciation of the Indian rupee as investors seek to capitalise on the growing economy.

So put simply, a higher GDP growth rate often correlates with a stronger and more sought-after national currency.

Challenges in currency forecasts

The primary challenge in currency forecasting is the unpredictable nature of global events, such as geopolitical conflicts or unexpected economic shifts. The COVID pandemic and Ukraine-Russia conflict are also very poignant examples of this.

Another notable example was the UK’s unstable political landscape in 2016/17, where speculation surrounding Theresa May’s hard Brexit plans resulted in the British pound falling to its lowest value versus the US dollar since 1985.

In addition to their unpredictability, the sheer volume of data in assessing the intricate connections between these types of global political events is another key factor for why  making accurate predictions is so difficult.

Currency Forecasts for Developing Countries

In developing countries, currency rate prediction is further complicated by factors like economic volatility, less stable political environments, and lower market liquidity. These elements can lead to more pronounced and rapid currency fluctuations.

Argentina is a great example of this, as they’ve experienced many of these factors throughout the last 5 years, resulting in the Argentine peso consistently losing significant value versus the British pound

Reliance on currency forecasts

While currency forecasts can be insightful, relying on them solely is a risky strategy.

Thankfully, there are alternative solutions available like hedging, by using forward contracts, that provide a way to manage currency risk.

Forward contracts, offered by currency brokers, allow businesses to lock in exchange rates for future transactions, incorporating factors like interest rate differentials between two currencies.

Interest rate differentials refer to the difference in interest rates set by the central banks of the countries whose currencies are being exchanged.

This differential is crucial because it can lead to what is known as a ‘carry trade’, where investors borrow in a currency with a lower interest rate and invest in a currency with a higher interest rate, profiting from the difference.

For example, if the interest rate in the Eurozone is 1% and in the U.S. it is 3%, an investor might borrow Euros at the lower rate and invest in U.S. dollar assets to gain from the higher U.S. interest rate.

In forward contract terms, this differential will be factored into the exchange rate agreed upon for the future transaction.

The currency from the country with the higher interest rate will typically be priced at a premium in the forward market, reflecting the expected gain from holding assets in that currency.

This mechanism helps businesses and investors hedge against potential currency fluctuations that could occur due to changes in interest rates over the period of the contract.

By locking in an exchange rate today for a transaction that will occur in the future, you can mitigate the risk of unforeseen currency movements affecting your financial planning or profitability.

Sounds good right? So how can you get started with implementing some hedging solutions?

Our top rated currency broker moneycorp has an extensive range of hedging services and award-winning customer service.

Their team of experts will be able to make a bespoke recommendation on the best hedging products, based on your unique needs.

Conclusion

Predicting currency rates is a complex task influenced by a multitude of economic, political, and market factors.

While mid to long-term forecasts are generally more reliable, the inherent uncertainties in the global financial markets make absolute accuracy challenging.

Alternatives to direct currency speculation, such as hedging strategies offered by currency brokers, offer safer ways to manage currency risk.