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Lesson 2 : Exchange Rates & Regimes

Module 1: Macro Fundamental Analysis

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Video Transcript

In the last video when we were talking about central banks being participants in the foreign exchange market we mentioned regimes and we’re going to look specifically at what exchange rate regimes are in this module so as we know exchange rates represents the price of one currency in relation to the price of another currency so exchange rates regimes are the mechanism by which the price of currencies are managed in order to facilitate global trade and investment this is often done using monetary and fiscal policies to achieve economic objectives such as full employment and price stability so that’s controlling inflation now price stability we will look further on in the course at full employment and what that actually means price stability if you take for example just as a side note the European union and the euro area price stability there is defined as a year-on-year increase of below two percent and full employment and price stability don’t forget are the dual mandate of central banks around the world so the central drivers of currency prices are as follows and these are very important because these are the factors which move the currency markets first of all the overall economic health so you’re looking at the businesses and the consumers within any given economy second we have monetary policy which is very significant and monetary policy is what comes from central banks it’s the managing of the currency in a given exchange rates regime we then have fiscal policy these are policies conducted by the government so instead of the central bank is conducted by the government such as for example the raising of taxes or perhaps the reducing of taxes and last but not least we have politics so what political decisions are being made this will also have an effect on not just GDP and the overall health of the economy but also the currencies of any countries where these political decisions are being made.

So what you’ll find is that money managers will actually look to preempt some of the central drivers of currency prices so they will look to predict the economic health they will look to predict future monetary policy future fiscal policy and also future political decisions or the impacts of political decisions so future impacts of current political decisions and they will look to place bets on the markets before these central drivers move currency prices one way or another so this speculation from investors based on the outcomes or even just the perceived outcomes of these four drivers is a significant factor behind currency pricing and fluctuations in the forex markets as we go through the course you will start to realize that if we can understand what the underlying economic health of a country is if we can understand what monetary policies are likely to be enacted what fiscal policies are likely to be enacted and what ramifications political decisions are going to have we will actually have a very good handle on the direction and the fundamental future movements in the currency pairs and the markets themselves so we’re now going to look at the different types of exchange rates regimes and the two different types of exchange rates regimes that we’re going to look at are fixed exchange rates regimes and floating exchange rate regimes so first of all we’re going to take a look at floating exchange rate to regimes floating exchange rates regimes are regimes in which prices are determined so the price of the currency is determined by the global supply and demand of that currency this means that they are determined by the market and not controlled by monetary authorities such as governments and central banks so the two main types of floating regimes are as follows first of all we have what’s called a free float so a free floating exchange rate regime a free floating exchange rate regime is a flexible exchange rate system which is exclusively determined by market forces so the supply and demand of foreign and domestic currencies so free floats operate without government and without any central bank intervention they are left to freely float as the name suggests in the open market free floating exchange rate regimes retain monetary independence but due to external shocks such as capital flight or fluctuations in oil prices free floating regimes are almost impossible to maintain so at some point the central bank or a government will have to step in if something happens in an economy which destabilizes it or could be a destabilizing force they will actually come in to mitigate that so because of this some level of government or central bank intervention is usually necessary as a result of this there are pretty much no free floating regimes in the global economy there’s some which are very close to it however there are none which are actually truly free floating regimes so the other type of floating regime is a managed float and this is by far the most common out of the two regimes so a managed float is a flexible exchange rate system in which governments and central banks intervene from time to time in order to guide a country’s domestic currency value down a desired path so this is very common this is what you’ll see in america in the UK and in the European Union etc pretty much all of the exchange rates regimes which are not fixed are managed floats one of the prime objectives behind government or central bank intervention is price stability so this is going back to the dual mandate of the central bank full employment price stability and we’re talking about managing inflation here and this is primarily carried out to counter external economic shocks as we’ve previously mentioned so maybe you get an oil shock or perhaps at the time of writing this we have an external economic shock in the form of covid19 virus we have external economic shock the value of the dollar let’s say explodes to the upside federal reserve steps in to devalue the dollar makes sense so managed floats are considered flexible exchange rates but with the added ability to suppress currency volatility and another way of actually looking at price stability the managing of inflation is also the suppression of currency volatility the reduction of volatility in currency prices via central bank and government intervention so now we’re going to have a look at fixed exchange rates or pegged exchange rates you may have heard the term before currency peg that’s what we’re going to be looking at in this video so a fixed exchange rate or a pegged exchange rate is a regime where a country’s monetary authority so the government or the central bank sets and maintains its exchange rate using the price of another currency a basket of currencies or a commodity such as gold so fixed exchange rates are designed to limit exchange rate volatility remember going back to the main participants in the foreign exchange market you have the large multinationals importers and exporters and they have problems when they have fluctuations large fluctuations in the exchange rate because this causes large fluctuations in their gross profit margins so one reason for a fixed exchange rate is to reduce the volatility so this actually helps facilitate trade and actually helps importers and exporters removing this problem of volatility in their gross profit margins now when fixed exchange rates fail so when pegs are broken or they’re removed enormous amounts of volatility can actually take place making pegged currencies potentially very risky to trade this is something you have to understand if you are trading the markets because we’ve seen historically very very large moves and moves which have wiped people out in the past when pegs have either been removed or broken so some recent examples of this are when the British pound peg was broken and the UK crashed out of the rm in 1992 you remember that George Soros trade which broke the bank of England quote unquote and this was because rather than the currency peg actually being removed by the central bank George Soros had effectively worked out how much foreign reserves the UK central bank had and he placed a bet which was large enough that he knew the central bank would not be able to defend the peg once it came under the pressure from the trade he was placing and also subsequent follow-through trades from other investors so quite famously from that trade he actually made a billion dollars in one afternoon and also sent interest rates through the roof in the UK and actually puts a number of people out of business so make up that what you will but it’s certainly a very famous trade in the financial world a more recent example of this was in 2015 when the swiss national bank removed the swiss franc peg from the euro and you will remember for those of you who are trading during that period the SNB governor Jordan telling everybody that they would maintain the peg and then they removed the peg pretty unexpectedly so there’s also a lesson in there somewhere about trusting central banks having said that traders should not really have been wiped out during either of these recent examples of pegs being broken or removed and that is just by one simple understanding which is that huge market volatility can come from fixed exchange rates and as a result especially if you’re a new trader and generally speaking even if you’ve been trading for a while you should really filter out pegged exchange rates and you should really be focusing on trading floating exchange rate regimes as a rule anybody who had done that or who understood the risks associated with fixed exchange rates would not have lost their shirt in those events and this is certainly something you have to consider when you’re trading in the future the us dollar was previously pegged to the value of gold and this was known as the gold standard.

So to maintain a fixed exchange rate a country’s monetary authority will intervene directly by buying and selling the domestic currency and they will use the foreign currency that it is pegged to in order to do so.

So if as an example country a fixes its exchange rate to that of country b the monetary authorities of country a must hold a large amount of foreign reserves in the currency of country b and this is because in order for a central bank of country a to maintain a peg it must buy and sell its own currency using or amassing the foreign reserves of country b so if it is buying its own currency it must use the foreign reserves of country b so it needs to use the currency of country b in order to buy its own currency and if it is selling its own currency converting out of its own currency to increase the supply and devalue the domestic currency then it will at the same time be amassing the currency of country b in the form of foreign reserves.

So remember in order to buy or sell one currency another currency must be bought or sold so here is what currency peg looks like on a chart this is the weekly euro swiss franc chart and this was the removal of the EurChf peg that we discussed and as you can see the peg was actually set at 1.2000 so the 120 peg in EurChf simply meant every time the euro declined against the swiss franc and approached the level of the 1.200 the Swiss National Bank would step in and it would buy euros and it would be exchanging those for swiss franc so it would be selling swiss francs and it would be buying euros so taking those swiss francs and buying euros with them this would actually appreciate the value of the euro and at the same time depreciate the value of the swiss franc now when the swiss national bank came out unexpectedly and announced that it would no longer defend the peg of 1.20 this meant that of course when the price got to the 1.20 handle there was nobody to step in and to buy euros converting out of swiss francs and this is what caused a huge devaluation of the euro against the swiss franc and this was the major revaluation in the swiss franc about 30% to the upside many people actually believed that this was easy money and that they just simply placed the stop loss at below the 1.20 and they could just keep buying the swiss franc on every dip and they would never get stopped out because the central bank would step in and this was what caused a lot of people to get wiped out when the swiss national bank said it would no longer step in to do that and very simply i mean this is a currency pair you can see when the peg was in place it really did not move a huge amount so there was no reason there was very little reward compared to the risk in terms of buying this to the upside and this is why we would actually always look to filter out pegged currency pairs so the two main types of fixed exchange rates regimes are Target Zones and Crawling Pegs.

So first of all we’re going to look at target zones now a target zone is a fixed exchange rate system where currency fluctuations are maintained within a target range or with an upper bound and a lower bound in relation to another currency or a basket of currencies target zones themselves can be separated into two categories the first is known as a strong target zone and this is where the exchange rate is maintained within a range of plus or minus one percent around the fixed central rate and second we have what’s known as a weak target zone and this is where the exchange rate is allowed to fluctuate by more than plus or minus one percent around the fixed central rate.

So target zone rate systems are fixed exchanges however they still allow for some degree of fluctuation as would take place in a floating exchange rate so volatility is permitted but it is limited and remember prices will be kept within their range within their peg by central banks using foreign exchange reserves to do so so the second fixed exchange rate system we’re going to look at is called a crawling peg.

Now a crawling peg is a fixed exchange rate system where currency fluctuations are maintained within a target range so the target zone that we just looked at in relation to another currency.

However the range is frequently adjusted by small amounts so up or down to allow for changes in economic data such as inflation so these small adjustments to the target range up and down are what gives it the name crawling peg so it is essentially a target zone so you may for example have a strong target zone with an upper bound of one percent and a lower bound of one percent but the difference between a crawling peg and a target zone is just the target zone is in and of itself static it doesn’t move whereas the crawling peg is a moving target zone so if you just imagine for a moment that you have your target zone which looks like this let’s say you have your mid-range right here this could be let’s say 1.20 on any given pair and you have your plus one percent upper bound and below you have your minus one percent lower bound and what will happen is if the currency actually goes up by one percent if it appreciates by one percent monetary authorities will start to sell the currency to push it back into this range and if it starts to devalue towards the lower bound of minus one percent below 1.20 they will start to buy the currency to appreciate the value back in the range so we have a range between here and here and that becomes your target zone now imagine taking the whole thing so you have just a rectangle like this for example okay this is your entire target zone and now imagine moving the whole of this zone up and down so you keep the structures in place here you have your plus one percent to the upside and your minus one percent to the downside but the one point twenty so the mid level goes up and down and of course as the mid level goes up so too will the lower bound and so too will the upper bound and as the mid-level price goes down so too will be dragged down the upper bound and also the lower bound that is your target zone here and the movement up and down so the changing of the mid price becomes the crawling peg.

Okay?

Now this system actually allows for gradual currency devaluation if the monetary authorities wish to do that and it reduces the volatility of the currency as a pegged exchange rate system and this actually deters currency speculation so just as we were discussing previously many people will avoid trading pegged currency pairs and because of this they tend to lack volatility unless or until of course the peg breaks or is removed by the monetary authorities.

Crawling pegs are commonly used by countries with weak currencies and as with any pegged or fixed system this type of regime limits the ability to operate monetary policy peg rate systems are fixed exchanges and they’re essentially target zone systems as we discussed however the difference is that they are frequently adjusted up and down to allow for incoming economic data.

Just like target zone systems they do still allow for some degree of fluctuation as would take place in a floating exchange rate however volatility is permitted but it is limited.

So please download the attach spreadsheet for global currencies overview and we’re going to jump over to this spreadsheet now and have a look inside so in the world currency overview spreadsheets that we put together for you you can see first of all in the a column we have the currencies by name in the b column we have the iso 4217 code and this is the code that you will see in your brokerage accounts so if for example you see GBPHUF you know that is the Great British pound against the Hungarian Forint we have in the c column the exchange rate regimes so if you look at the key down here you can see that floating exchange rates are represented with a zero and most of these are actually represented with a zero and fixed exchange rates or the pegged systems are highlighted in gray and they are represented by the number one so any currency with a one next to it here you know is a pegged currency and we actually have the pegs down here so for example the danish chrono is pegged to the euro and we have the exact peg over here so you can see plus or minus 2.25 percent so this is what would be a weak target zone based on what we discussed in previous slides you can see the Hong Kong dollar over here is pegged to the us dollar in a range and you can see the Singapore dollar and the Chinese yuan are pegged to a basket of currencies and they are undisclosed because they want to deter speculators from placing bets on pegs breaking uh just like we talked about with the George Soros trade and the Bank of England previously in the f column we have the commodity currencies so these are currencies which are exposed to commodity prices and they are linked to the price of commodities so if the commodity the relevant commodity for example let’s say crude oil and the Canadian dollar if crude oil is rising this is actually beneficial for the Canadian dollar and these currencies which are highlighted and labeled with one are the commodity currencies any currency down here which has a zero which isn’t highlighted isn’t a non-commodity currency so this means that all of these currencies here all the way down to the Singapore dollar are not majorly influenced by commodity prices in the way that these currencies are in the g column we have the designation so this is the geographical designation you can see down here we have developed economies we have the Europe, Middle East and African economies we have the Asian and we have the Latin American and they’re also color coded with green blue red and yellow and in the h column we actually have the different central banks of the countries which are represented by each of these currencies and we have the links through to the central bank websites so you can click on any of these go straight through to the central bank and you can view for example some of the latest releases or if there is an interest rate decision this is where you will find these interest rate decisions on the actual central bank websites so as an example you may wish to click on the federal reserve link and this will take you through to the central bank of the us so the federal reserve website and you will see this will be pretty much the same format across all of the central banks they will differ slightly of course but generally speaking you’ll be able to click on see the latest news and events the press releases from that central bank.

And you will see you can actually access all of the central bank statements as they are released and as i said before this will also include statements rate statements and also minutes from FOMC meetings and if you click on for example if we go back and look.

At the federal reserve issues FOMC statement on the 10th of the 6th you can see we can click on this and this will bring up the exact statement which is released and this will be released straight away onto this website this will be the first place that this statement is actually released and as you can see in fact talking about straight off the bat here the promotion of its dual mandate which we discussed in previous slides being maximum employment full employment and its price stability goals.

So if we just jump back to the spreadsheet quickly uh you can see also just by applying the filter here you can actually order these in any which way you like you can quite quickly just sort by smallest largest or largest smallest to see which currencies are in which exchange rates regime you can see by doing the same quite quickly which currencies are exposed to commodity prices and which countries are not and if you so wish as well you can actually see which designation geographically these currencies are by filtering these as well so finally if you were just to click through to the second tab here the free economic data you can see we have a resource here which actually takes you through to a website called trading economics we do not have any involvement with this website we do not have any agreements this is not a promotion or a cross promotion or anything like that we are simply providing you with this resource because the data they provide is free and it is in line with the free course that we are also providing so it is a very good free resource if we click on for example the top link up here which is for Australia you will see it takes you straight through to the website and it takes you directly to the Australian economic data so all of this data is actually released by the country for free so it’s free data anyway however this website compiles it all into one place so you can very easily click through without any cost at all and just see what the latest economic releases are and we will be showing you as we go through the course what pieces of data are the most important how to put them together to form an overall picture of the underlying health of the economy and how this will affect the relevant currencies of the economy which you’re looking at so for example you can just click on GDP annual growth rate and it will show you the latest releases for Australian GDP etc.

So that brings us to the end of this video and you can put this spreadsheet away and you can reference this back at any point and hopefully you will find this useful and it’ll be a good resource to keep reference into as we go through the course and you start to learn more and more about the economic data and how you can use it to form a macro economic analysis.