We wrote last week about exchange rates. The article inspired a few people to get in touch – including people thinking of travelling to the US – so this week we thought we would write some more about what actually causes exchange rates to fluctuate. You might paraphrase this article as “why has the US become so much more expensive?”
The basic principle with exchange rates is that businesses in the US want to be paid in $US, and businesses in Australia want to be paid in $A. So, when an Australian wants to buy something from a US business, that Australian must first buy some $US. And vice versa.
Australians and Americans buy the other country’s dollars in the foreign exchange market. This market responds to supply and demand factors just like any other market. When demand for something in the market increases, so does the price. When supply of something in that market increases, the price of that thing usually falls.
Now think of an Australian who wants to take a holiday in the US. They will need some US currency to buy food, accommodation, entry tickets, etc. So, they need to buy some $US. They (usually through their bank) take their $A along to the market. The thing they want is $US, so their presence in the market increases demand for $US. This increases the price of $US. At the same time, when they buy the $US, they use $A to do so. This increases the supply of $A in the market, which reduces the price of $A.
So, a single buyer wanting to use $As to buy $USs will simultaneously increase the price of the $US while reducing the market price of the $A. This means the exchange rate of the $US rises.
Of course, this example is very simplistic. No single buyer can really affect the market price. The entire foreign exchange market around the world (exchanges in currency between all the nations of the world) is estimated to be $US6.6 trillion per day. You or I taking a holiday and wanting a few thousand $US will not move the price in such a huge market!
But really big changes in demand and supply will. So, if there is something in the US that a lot of people want to buy, the total effect of that increased demand will raise the $US exchange rate.
Recently, this has been the case. There is something that many people in countries other than the US want to buy. That ‘thing’ is investments in interest-bearing investments in the US. Because US interest rates have risen so fast, people around the world are being encouraged to invest in products that pay interest at US market rates. And to do this, those people need first to buy $US.
At the same time, investors in the US are discouraged from investing their money in other currencies. This reduces the supply of $US in the market.
Simultaneously, we have seen demand the price of world oil increase sharply. Usually, oil producers want to be paid in $US, meaning that people who want to buy oil need first to buy $US. If the price of oil increases, they also need more $US. So, increasing oil prices also drive up demand for $US.
These two things – the spike in the oil price and the increase in US interest rates – have worked together to increase the price of $US compared to other currencies.
The specific nature of demand for the $US is also why the $A has not moved so much when compared to other currencies. Here is the way the $A has moved compared to the Euro over the last 12 months (thanks to Google):
In this graph, you can see that it was the $A that become more expensive compared to the Euro, but that the value is falling again now. This is because, from about March this year, interest rates in Australia were higher than in Europe. Here is the graph of interest rates in Australia and rates in Europe over the past 12 months, thanks to Trading Economics:
The blue line is the rate in Australia, which was higher than in Europe until recently. When the two interest rates come together, the value of the $A falls compared to the Euro. Right now, the European interest rate is higher than in Australia, just as it was 12 months ago. And the $A is back where it was in terms of the European exchange rate.
That is another reason why changes in exchange rates are not bad news for everybody. Australian borrowers are slightly better off than their US counterparts. But Australian travellers to the US are worse off. Presumably, travellers with a mortgage are breaking about even!
In summary, if you really want to take that overseas holiday, maybe just avoid the US this year. Wait until their interest rates look a little bit more like ours.
