What Is Exchange Rate Volatility?
The World is kind of topsy-turvy at the moment.
The “all-mighty” Greenback has seen a slight faulter with investors and traders alike having less anxiety – at least on the face of it – around emerging market currencies.
What? Can that be right? Are traders showing faith in emerging markets over the US Dollar?
In an article by J.P Morgan Currency Volatility: Will a Strong US Dollar Return?, they set out as follows –
“2022 was a historic year. The U.S. dollar strengthened against nearly every other major currency to levels not seen in decades, as the Federal Reserve (Fed) aggressively hiked interest rates in a bid to combat inflation. On the whole, the nominal broad dollar index — which is used to measure the value of the dollar against a basket of currencies widely used in international trade — appreciated over 12% in 2022.
However, the greenback has trended weaker since, sending ripples through currency markets around the world.
As for other major currencies, J.P. Morgan Research is bullish on the yen, neutral on the euro and bearish on the pound in 2023”.
Conversely in another article on Moneyweb titled Emerging-market currency volatility erases war-time spike, emerging markets seem to be on the up –
“Options traders have cut their expectations of currency volatility in emerging markets to levels seen before Russia invaded Ukraine in February 2022.
The JPMorgan Emerging Market Volatility Index, an indicator of foreign-exchange swings three months ahead, fell to 8.86% on Friday. That was the first time since the war began that the measure closed below 9% and marked the lowest level for the gauge since October 2021.
The lowering of traders’ anxiety about emerging-market currencies signals optimism the US dollar’s downward trend this year will continue. As the Federal Reserve takes a mini pause in interest-rate hikes, and some developing nations halt them, money managers expect the global tightening cycle that began more than two years ago to peak and reverse”.
You see? Markets – at least for the moment – feel kind of turned on their heads which leads us all to wonder how, or what affects the volatility of exchange rates.
Factors that affect exchange rates
Fist things first. Do you still remember what an exchange rate is?
For a quick recap – the most common way to value a currency is through its exchange rates. Exchange rates can be either fixed (set to a pre-established standard such as gold) or floating (which allows the foreign exchange market determine currency value with respect to the supply and demand of other currencies). Exchange rates therefore play a critical role in how a country is able to trade – or more specifically – how much or how little they can trade.
Which leads us to wonder – why are exchange rates so temperamental (or as we should correctly say – volatile)?
Exchange-rate volatility refers to abrupt and significant fluctuations in exchange rates. And it often receives significant attention in the field of international finance (especially in emerging market economies). Why? Because excessive exchange-rate volatility can complicate trade and investment decisions. And that can further hinder a country’s economic growth.
Not ideal (which is kind of an understatement).
The thing is, there are different views on the sources of this volatility –
- is it primarily influenced by global factors, or
- do domestic factors play a more significant role?
But the truth is, it’s not one or the other. Instead, it’s a melting pot of various potential drivers of exchange-rate volatility that includes both local and international macroeconomic surprises.
For example, since the global financial crisis, currency volatility has been a widespread phenomenon. Worldwide. With particularly unfavourable knock-on effects on emerging-market countries.
The South African rand (as an emerging-market currency) has been particularly – and significantly – impacted by this global trend.
What are some of the causes of this?
To better understand the different impacts on exchange rate volatility, especially where South Africa is concerned, we turned – once again – to PR Nel, the currency and treasury Manager at Kuda FX –
“High volatility, or “excess” volatility, creates uncertainty about future exchange rate movements, which can negatively impact investment activity, economic growth, and job creation. It’s therefore crucial to identify the drivers of volatility and determine whether policies can be implemented to reduce it.
In the case of South Africa specifically, macroeconomic anomalies have limited impact, while global factors – including commodity price volatility and financial-market risk perceptions – play a significant role in driving the rand’s volatility.
Additionally, local political uncertainty is a substantial contributor. While South Africa cannot control global factors, policymakers can influence the perception of political uncertainty through effective economic policy development, implementation, and communication.
By promoting greater policy and political predictability, South Africa could potentially mitigate the rand’s volatility and promote stability in its currency”.
Looking at the markets and the current upside-down nature of the US dollar vs emerging market currency, it leads a lot of us to question (especially where our own local markets are concerned), what could impact the strength of the rand in the coming months? What should we be on the loom out for?
According to Nel, the following factors could play a role –
- Political Uncertainty: South Africa has faced political instability and governance challenges in recent years. This includes issues such as corruption, policy uncertainty, and state-owned enterprise mismanagement. Political developments and policy decisions significantly impact investor confidence and contribute to rand volatility. Additionally, recent allegations of weapon-related sanctions against South Africa have raised concerns among investors, potentially leading to economic repercussions and further rand volatility. If South Africa faces sanctions that restrict or limit its ability to export goods to trading partners in the US and EU, it could lead to a decline in export revenues. This would negatively affect the country’s balance of payments and put additional pressure on the rand’s value. Reduced export earnings may lead to a decrease in foreign exchange reserves. Furthermore, sanctions may create uncertainty and damage investor sentiment, leading to capital outflows and exacerbating rand volatility. The bottom line – foreign investors will become more cautious, electing to sidestep investment in a country that could be facing upheaval.
- Inflationary Pressure: South Africa has struggled with relatively high inflation rates for several years now, which has led to the erosion of purchasing power of the currency. In response, the South African Reserve Bank (SARB) may raise interest rates to curb inflation, attracting foreign investors seeking higher returns. However, this can also lead to capital outflows and currency depreciation. Why? Because high inflation and interest rates contribute to the rand’s volatility. You see, in increasing interest rates, it causes investors to question the measurable effectiveness of these measures to control the high inflation rates.
- Interest Rate Paradox: SARB’s interest rate decisions, intended to influence economic growth and inflation, do not always yield the expected results. High-interest rates are implemented to curb inflation, attract foreign investors, and stabilize the rand. However, if interest rates are perceived as excessively high or the impact on economic growth is not as expected, investors may become cautious and withdraw their capital, leading to rand depreciation.
- Load Shedding: South Africa has been plagued by power supply issues, leading to frequent “load shedding” that has reduced top-line productivity in a number of sectors. Electricity shortages disrupt business operations and put a dampener on investor confidence. The uncertainty surrounding the power supply crisis adds to an already volatile environment – can the South African economy rise-up to the challenges being faced by the power supply crisis and continue to perform despite the odds?
- BRICS Summit and Investor Nervousness: South Africa is a member of BRICS (Brazil, Russia, India, China, South Africa), which is a group of emerging economies. Developments within the BRICS nations, such as the upcoming BRICS summit (to be held from 22 – 24 August 2023), can cause investor nervousness and affect the rand’s value. Investors closely monitor the economic and political dynamics of these countries, as any disruptions or policy shifts can lead to capital outflows from South Africa and increase rand volatility. What will happen – especially where Russia and South Africa potentially hosting Russia is concerned – that may have a negative knock-on effect on the rands volatility.
- US Debt Ceiling: The United States imposing a debt ceiling creates global market uncertainties. Investors become cautious, and risk aversion increases, the rand could experience heightened volatility during such periods as investors seek safer investment options.
Given the unpredictable nature of currency markets, it becomes crucial to manage and mitigate the risks associated with currency volatility. One way to address this is by partnering with a reliable foreign exchange provider such as Kuda FX. By leveraging the expertise and services offered by Kuda FX, businesses and individuals alike can navigate the fluctuations in the rand’s value more effectively, minimizing potential losses and capitalizing on opportunities for favorable exchange rates.
And that’s really the aim of the game. We think.
Kuda FX is perfectly poised to provide valuable insights, market analysis, and tailored solutions to help clients make informed decisions regarding their forex transactions. Kuda FX’s expertise can assist in managing the risks associated with currency volatility, allowing businesses to focus on their core operations and financial stability. And by partnering with a trusted foreign exchange provider like Kuda FX, one can mitigate the inherent risks associated with exchange rate volatility and instead take advantage of opportunities that arise from the fluctuations in the exchange rate.
With that in mind, we encourage you to get in touch with a Kuda FX professional, like our team at Kuda FX who would be happy to explain the above concepts in further detail or provide any other assistance you may require with your specific forex needs.
In fact, if you have any queries on the information we have set out above, please feel free to get in touch with us.