It’s a market that’s running continuously for 24 hours per weekday around the world – and transactions can happen using different mechanisms, such as spot transactions, outright forwards, foreign exchange swaps, currency swaps, or the use of other types of options. But what fuels changes in this extremely liquid and busy market, and why are the exchange rates between countries constantly in flux?
Key Market Factors
Today’s infographic comes to us from Hiwayfx and it highlights six of the major factors that can impact currency exchange rates.
As with many things in macroeconomics, it’s important to note that many of these factors are related and can feed off each other. For example, a high rate of inflation can lead to central bank intervention, such as raising interest rates and buying or selling domestic currency. This could lead to an increase in government debt, and so on.
What Influences Exchange Rates?
Here are the six factors summed up again:
- Government Intervention: Central banks can influence rates by buying or selling the domestic currency.
- Inflation: Countries with consistently high inflation rates tend to have lower currency values. This is because purchasing value decreases relative to other countries.
- Interest Rates: A rise in interest rates in a country can offer investors a higher rate of return than other countries. As a result, the currency can appreciate relative to other countries.
- Current Account Deficits: If a country has a current account deficit, it means that it’s spending more than it’s earning in foreign trade. To make up this deficit, countries may borrow capital from other external sources, which in turn will help make the domestic currency depreciate.
- Government Debt: Countries with high amounts of debt are less attractive to foreign investors due to the chance of default as well as possible high inflation rates. This can decrease the currency’s value.
- Speculation: Most trades in the forex markets are speculative trades, which means that sentiment and momentum can play big roles in market activity. Even if the fundamentals don’t align, the market for a currency can continue soaring or depreciating if traders and governments perceive it should.
For a related topic, see a map of the countries with the most foreign currency reserves.
on The good news is that the Federal Reserve, U.S. Treasury, and Federal Deposit Insurance Corporation are taking action to restore confidence and take the appropriate measures to help provide stability in the market. With this in mind, the above infographic from New York Life Investments looks at the factors that impact bonds, how different types of bonds have historically performed across market environments, and the current bond market volatility in a broader context.
Bond Market Returns
Bonds had a historic year in 2022, posting one of the worst returns ever recorded. As interest rates rose at the fastest pace in 40 years, it pushed bond prices lower due to their inverse relationship. In a rare year, bonds dropped 13%.
Source: FactSet, 01/02/2023.
Bond prices are only one part of a bond’s total return—the other looks at the income a bond provides. As interest rates have increased in the last year, it has driven higher bond yields in 2023.
Source: YCharts, 3/20/2023.
With this recent performance in mind, let’s look at some other key factors that impact the bond market.
Factors Impacting Bond Markets
Interest rates play a central role in bond market dynamics. This is because they affect a bond’s price. When rates are rising, existing bonds with lower rates are less valuable and prices decline. When rates are dropping, existing bonds with higher rates are more valuable and their prices rise. In March, the Federal Reserve raised rates 25 basis points to fall within the 4.75%-5.00% range, a level not seen since September 2007. Here are projections for where the federal funds rate is headed in 2023:
Federal Reserve Projection*: 5.1% Economist Projections**: 5.3%
*Based on median estimates in the March summary of quarterly economic projections.**Projections based on March 10-15 Bloomberg economist survey. Together, interest rates and the macroenvironment can have a positive or negative effect on bonds.
Positive
Here are three variables that may affect bond prices in a positive direction:
Lower Inflation: Reduces likelihood of interest rate hikes. Lower Interest Rates: When rates are falling, bond prices are typically higher. Recession: Can prompt a cut in interest rates, boosting bond prices.
Negative
On the other hand, here are variables that may negatively impact bond prices:
Higher Inflation: Can increase the likelihood of the Federal Reserve to raise interest rates. Rising Interest Rates: Interest rate hikes lead bond prices to fall. Weaker Fundamentals: When a bond’s credit risk gets worse, its price can drop. Credit risk indicates the chance of a default, the risk of a bond issuer not making interest payments within a given time period.
Bonds have been impacted by these negative factors since inflation started rising in March 2021.
Fixed Income Opportunities
Below, we show the types of bonds that have had the best performance during rising rates and recessions.
Source: Derek Horstmeyer, George Mason University 12/3/2022. As we can see, U.S. ultrashort bonds performed the best during rising rates. Mortgage bonds outperformed during recessions, averaging 11.4% returns, but with higher volatility. U.S. long-term bonds had 7.7% average returns, the best across all market conditions. In fact, they were also a close second during recessions. When rates are rising, ultrashort bonds allow investors to capture higher rates when they mature, often with lower historical volatility.
A Closer Look at Bond Market Volatility
While bond market volatility has jumped this year, current dislocations may provide investment opportunities. Bond dislocations allow investors to buy at lower prices, factoring in that the fundamental quality of the bond remains strong. With this in mind, here are two areas of the bond market that may provide opportunities for investors:
Investment-Grade Corporate Bonds: Higher credit quality makes them potentially less vulnerable to increasing interest rates. Intermediate Bonds (2-10 Years): Allow investors to lock in higher rates.
Both types of bonds focus on quality and capturing higher yields when faced with challenging market conditions.
Finding the Upside
Much of the volatility seen in the banking sector was due to banks buying bonds during the pandemic—or even earlier—at a time when interest rates were historically low. Since then, rates have climbed considerably. Should rates moderate or stop increasing, this may present better market conditions for bonds. In this way, today’s steep discount in bond markets may present an attractive opportunity for price appreciation. At the same time, investors can potentially lock in strong yields as inflation may subside in the coming years ahead. Learn more about bond investing strategies with New York Life Investments.
