On a single day in August 2019, China’s currency, the renminbi (or yuan), suddenly and unexpectedly dropped to its lowest level against the US dollar in more than a decade.
That same day, Australia’s All Ordinaries index dropped 2%, wiping some $38 billion off the local market.
If you’re wondering how a fluctuation in the exchange rate between two foreign countries had such a brutal short-term impact on Australian investors you are surely not alone. Welcome to the complex world of currency and stock market interactions.
How are currency and stock movements linked?
To understand how currency movements affect stock markets, it helps to understand just how big the foreign exchange or forex market is. On a daily basis, more than $6.5 trillion is traded in forex, mostly to facilitate cross-border transactions, dwarfing the volume in global stock markets.
That’s a lot of money darting from one corner of the globe to another, which has significant economic implications. Llet’s take a brief look at the major currencies and how Australia fits into the global picture.
The top five most traded currencies in the world are:
US dollar
Euro
Japanese yen
British pound
Australian dollar
The Australian dollar is more significant to the global currency market than many would imagine, but the US dollar remains the currency that all others are measured against.
When a reporter says “the Aussie dollar has fallen” on the news, what they really mean is that it has fallen against the US dollar – though it may well have fallen against other currencies as well.
Despite being the world’s second largest economy, China’s share of the global currency market is still relatively small – though it is growing in significance.
Currencies and economies
So why are currencies significant for stock markets? Arguably, the main reason is that currency fluctuations have an impact on the broader economy, which affects the performance of businesses.
A fall in one nation’s currency, say the Australian dollar, will make its exports cheaper, helping businesses that sell overseas, while making imports more expensive, potentially hurting consumers and retailers.
All things being equal, a lower Australian dollar will help lift the performance of export-orientated businesses and hurt import-orientated and consumer-facing businesses, which will therefore affect stock prices.
So how does the renminbi fall fit with this dynamic? A weaker RMB makes Chinese exports cheaper and imports to China more expensive. As Australia’s largest trading partner, that’s bad news for a whole range of Aussie businesses from food producers to iron ore miners.
However, the main reason for the strong reaction on stock markets almost certainly had a lot to do with the timing of the fall, which came days after then-US President Donald Trump announced new tariffs on $US300 billion worth of Chinese goods.
Quite simply, the fall in the RMB was seen by markets as an escalation in a trade dispute that could have significant ramifications or the global economy and as a sign China, which exercises greater direct control over its currency than most western liberal democracies, may be willing to weaponise its exchange rate in the dispute.
While this is an extreme example of currency fluctuations affecting share markets, foreign exchange movements can affect stocks in other ways as well. Here are a few examples:
Companies with overseas earnings: A weaker Australian dollar is good news for companies that earn a substantial amount of their income overseas since every US dollar they earn is now worth more back home, providing a potential boost to their bottom line and dividends, which could make its stock more attractive to investors.
Carry trade: A lower Australian dollar can make local stocks more attractive to overseas buyers, especially if they believe the currency will rebound at some point.
Say a US investor decides to invest $US10,000 in Australian shares when the AUD is worth US70 cents and sells them a year later when the AUD has climbed to US77 cents. They would have made a 10% profit before taking into account stock price moves and dividends. This is where the so-called carry trade– in which investors borrow money in a currency where lower interest rates are available and invest it in a different currency with the goal of securing higher returns – also comes into play.
However, in the example above, if the AUD had moved in the opposite direction and fallen to US63 cents, the investor would have instead occurred a 10% loss.
The lowdown
It is clear currency movements can and do have an impact on stocks, both in terms of individual securities and broader markets. However, it’s important to note that foreign exchange is only one of many factors affecting both the economy and businesses so it’s important to do your research before using currency movements to guide your investment activities.
