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Macroeconomics Set To Be The Main Force In FX Markets Post Pandemic

Written by A Sweeney: CIFER Economist

17th June 2021

Forecasting intermediate term future FX rates is notoriously difficult, proven by the the literature on the topic. This is because it requires forecasting two different countries currency valuations - for example, GBP/USD would require an understanding of independent macro policies for the GBP and similarly for the USD to then make assumptions and predictions for the pair. Furthermore, global sentiment within financial market and commodity pricing also plays a role in currency valuations.

The FX Market has so many market participants using their own methods and reasoning, some are technical analysts, some are arbitrage traders and there is also the case of international business and trade using FX spot and forward market to secure pricing. This gives high volume and volatility that can be utilised for short term speculation however what about intermediate - long term forecasting? How do Governments and Central Banks know how their currency should be valued in order to remain internationally competitive in the goods and money markets? Well, it comes down to interest rate differentials and having a solid understanding in international macro policies in developed and emerging economies. 

A fundamental component of the medium-long term currency moves is the relationship between the current account and the state of the real economy. For example; running large current account deficits is not sustainable and will eventually result in a depreciation of the domestic currency. However, using fundamental macros to predict a timeline for currency moves is difficult but the literature is well supportive of large corrections in currency valuations for economies operating a large current account deficit. Furthermore, other factors such as productivity levels in long run also explain larger currency moves. The 'Balassa-Samuelson' effect states that countries with high productivity levels in their traded goods sectors typically have stronger currencies which reflects rapidly advancing emerging markets such as China and India. 

The macro framework post covid would favour long run strength in the Indian Rupee and Chinese Renminbi as highly productive countries, also the US dollar as inflationary pressure will cause a rise in interest rates creating arbitrage opportunities from cross border rate differentials. Sticking with macro theory, low productivity in the UK due to long periods of lockdowns and restrictions coupled with trade difficulties, capital movement and immigration leaving a gap in the labour market as a result of Brexit, the long run outlook for the British Pound points towards significant deprecation. 

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