If you have been following the news at all over the last year, one thing that has remained almost a constant theme is how volatile the financial markets have been. Thanks mainly to the economic impact of the COVID-19 pandemic, which has thrown the global economy into chaos, both the stock markets and the currency markets have exhibited significant amounts of volatility.
Although currency fluctuations are frequently mentioned in the forex market news, however they are explained, we never get a sense of the relationship between the currency markets and the stock or equity markets. Although we might assume that volatility in one market will cause fluctuations in the other, this might not necessarily always be the case. With that said, what causes currency fluctuations, and what impact, if any, does this have on the stock market and the value of companies?
What causes currency fluctuations?
Out of all the various financial markets currently in existence, currency markets — also known as ‘Forex’ markets — are perhaps the most reactive to the daily news cycle. Given how closely related the value of a currency is to the country’s economic health and political stability to which it is tied, the value of a currency will ebb and flow in response to this over the trading day. For this reason, news of political developments will often result in fluctuations in the value of currencies as traders react to it and find ways of incorporating it into their strategy.
How do currency fluctuations impact the stock market?
But as even the most inexperienced online traders and investors know, the stock market and the forex market are not the same. Given that they are separate and shaped by their own unique trading environments, how do developments in one impact the other?
Although the economics behind this process can be quite complex, there are several fundamental reasons why fluctuations and changes in the value of currencies might generally impact the stock market or the value of a specific stock.
The first thing we need to remember when trying to understand this is that as currencies are always paired — i.e., you need one currency to buy another — while a drop in the value of one currency might be bad news for one individual, it will inevitably be good news for someone else.
For example, if the value of the GBP falls against the value of the USD, while this is bad news for a tourist from the UK hoping to visit New York, for the American tourist visiting London, the opposite is true.
While this example tells us a lot about tourists and why falls in currency prices make it attractive to visit a desired holiday destination, the same is true for companies!
Companies will often use drops in currency prices to buy up foreign currencies when the prices are low relative to their “home” currency, which can then be used in the future. For example, if the EUR falls against the USD, this would be a good time for Apple to acquire some Euros to be used later within Europe as working capital.
That is just one way that currency prices might impact the value of a company. Another critical factor is what the currency price means for individuals living in specific countries. This is because currency fluctuations will inevitably have an impact on not only how expensive it is for individual consumers to import goods but also how much it costs companies to import the materials needed to manufacture those goods. In this sense, currency fluctuations will have an impact on how much it costs a business to operate and, as a result, their profit margins. This will all be taken into account by traders and investors, which will, in time, be reflected in the price of a particular stock on the stock market.
More generally, currency prices will have an impact on the rate of inflation in a particular country’s economy, which will have a noticeable impact on the ability of individual consumers to purchase goods or services. In this sense, currency fluctuations can have a significant and important impact on the stock price of companies.