As some of you may have experienced, the foreign exchange market can bring joy or great frustration. Large swings can be sudden, rapid and unpredictable. Lately the British pound has had a good run against the antipodean currencies and in this brief wrap up, I will aim to explain the dominant factors that are currently affecting these exchange rates.

We will start with a two graphs to give you a clear overview of the market action in the past six months.

First, the Pound to Aussie

Secondly, the Pound to Kiwi

These charts are called “candle charts” with each candle representing a period in time. A blue candle represents a situation when the rate has moved higher, contra a red candle representing a move lower. These charts give you a clear indication that the Kiwi has been grinding lower all through this year, and the volatility in recent weeks only serves as an extension of the already established trend. The Aussie on the other hand had been relatively stable up until about a month ago when there was a sudden spike, with a subsequent correction.

So what is causing the rates to fluctuate in this seemingly unpredictable fashion?

Now, in order to really understand what affects the relative values in exchange rates, we must understand the way rates are set. In foreign exchange the benchmark currency is the US dollar and all other currency pairs are called cross rates. A straight forward example of a cross rate is GPB/AUD, but the same rate can be obtained going through the US dollar with a simple mathematical calculation. Consequently the GBP/USD rate multiplied by the USD/AUD exchange rate equals GBP/AUD, this since the US dollars simply cancel each other out using algebra. As an example, if we have got a GBP/AUD rate of 2.40 then this rate can be obtained multiplying a GBP/USD rate of 1.7777 with the USD/AUD rate of 1.35.

The reason for bringing this up is that the recent developments in our cross rates have had their origin in the relation to the US dollar. What I’m implying is that if the British pound manages to gain ground against the US dollar and the Aussie at the same time tumbles against the US dollar, then this implies a higher cross rate for GBP/AUD.

The general reason for the antipodean currencies continuously grinding lower ever since the start of 2005, I would assign to the eroding interest rate gap against other major currencies and the associated unwinding of the carry trade (explained below). Since interest rates have been relatively high “down under”, a lot of money has been invested here to take advantage of these higher yields. But with rates on the rise in other places of the world there is now greater competition for these investment flows, resulting in less investments and even liquidation “down under”. The way the so called carry trade works is that you borrow in one currency at a relatively low interest rate and then invest the borrowed funds in a higher yielding currency. The spread or difference in the interest rates will serve as the base for your profits on that trade, although the profits will be exposed to adverse movements in exchange rates.

Lately the market has been extremely focused on rising interest rates in America in addition to Europe and with an increasing herd of yield seeking investors taking positions in these currencies this has in effect led to a comparable “unwinding” of previous positions “down under”. The resulting selling of Aussie and Kiwi dollars in favour of Euro and US dollar has led to lower relative values in their exchange rates.

The British pound on the other hand has had a relatively low and stable interest rate for quite some time and hasn’t been involved in the same carry trade business. For this reason, the most recent sell off in the antipodean currencies didn’t lead to an equivalent sell off in the pound. This detail is one of the main reason for the most recent spike in the cross rates of GBP/AUD and GBP/NZD.