What is the impact of exchange rates, and why are they important?
Exchange rates are often considered primarily when planning a holiday abroad. However, fluctuations in a currency’s value impact far more than just travel costs. Understanding these dynamics can assist individuals and businesses in adapting to challenges and seizing potential opportunities.
Exchange rates are fundamentally relative. Simply put, they represent the cost of one nation’s currency compared to another. However, these rates are not isolated; various factors influence them, often connected to economic variables and global events.
Key drivers behind exchange rate fluctuations
Inflation plays a crucial role in determining exchange rates. Countries with low inflation often benefit from stronger currencies, as their purchasing power remains stable over time. In contrast, nations experiencing high inflation typically see their currencies weaken. A strong currency signifies financial stability, providing it with an advantage in the international market.
Interest rates represent another factor to consider. When interest rates increase, assets like government bonds become more attractive, drawing foreign investment. This influx of capital strengthens the local currency, as demand rises to fund these investments.
How political and economic stability influence currencies
Political and economic stability also influence exchange rates. Countries with robust, growing economies and effective governance often attract foreign investors. Such investments enhance demand for the national currency, consequently increasing its value. Stability conveys a clear message of trust and reliability, qualities that are essential for long-term investors.
In this context, the US dollar emerges as the world’s primary reserve currency. Its function as a safe haven is particularly vital during periods of global financial uncertainty. Numerous countries hold reserves in dollars to mitigate economic shocks or settle international debts, thereby enhancing its appeal.
New US trade tariffs and their ripple effect
President Donald Trump’s announcement of new US trade tariffs in February 2025 is poised to significantly impact global exchange rates. The tariffs, aimed at reducing the US trade deficit, if enacted, will impose higher duties on imports to the United States. While these measures are intended to bolster domestic production, they will inadvertently affect currencies worldwide, including the pound.
The announcement of these tariffs led to a heightened demand for the dollar, as global trade participants required it for transactions involving American goods. However, this effect will adversely impact other currencies, such as the euro, while UK exporters will also be affected when sending goods to the US, a vital trading partner.
A weaker pound and its upsides
The pound’s value against the dollar fluctuated significantly in 2024, and new US policies in 2025 have added further strain. Although a weaker pound may initially seem concerning, it actually presents opportunities for exporters. For UK businesses selling goods abroad, a decline in the pound’s value makes these goods more affordable for foreign buyers, potentially boosting sales.
Another indirect benefit of a weaker pound is its impact on the FTSE 100, the UK’s premier stock market index. Numerous FTSE 100 companies derive substantial revenues from international markets, primarily denominated in US dollars. When the pound depreciates, these dollar earnings convert into more pounds, thereby enhancing the value of their revenues.
The challenges of a declining pound
However, the drawbacks of a weakened pound cannot be ignored. For UK importers and manufacturers reliant on global supply chains, a diminished currency value results in higher costs for goods and materials. With the introduction of new US tariffs, these costs could be further aggravated, particularly for businesses that rely heavily on trade with America. Rising import prices ultimately affect consumers, contributing to widespread inflation.
This inflation poses a considerable challenge for individuals on fixed incomes, such as pensioners or employees who have not received recent pay rises. Their reduced purchasing power makes them particularly vulnerable, as rising prices increasingly strain their finances.
Why exchange rates shouldn’t dictate investment decisions
Due to their complexity, accurately predicting currency movements is nearly impossible. Exchange rate fluctuations are just one of the many variables impacting overall investment performance. Therefore, it is unwise to base investment decisions primarily on foreign exchange rates.
Instead, focusing on long-term goals is the wisest course of action. Diversification – distributing funds across various asset classes and regions – is vital for reducing the risks associated with fluctuating currencies and shifting economic conditions.
Securing a financial future with professional advice
The introduction of trade tariffs, along with currency and market fluctuations, emphasises the increasing complexity of constructing a balanced and diversified investment portfolio. This is why seeking professional financial advice can significantly impact your financial strategy. We can help you in structuring a portfolio designed not only to withstand economic shocks but also to maintain and enhance your money’s purchasing power.
A secure financial future necessitates careful planning and thoughtful decisions. If you are prepared to achieve your goals and safeguard your finances from market uncertainties, it is beneficial to seek personalised guidance.
THIS ARTICLE DOES NOT CONSTITUTE TAX, LEGAL OR FINANCIAL ADVICE AND SHOULD NOT BE RELIED UPON AS SUCH. TAX TREATMENT DEPENDS ON THE INDIVIDUAL CIRCUMSTANCES OF EACH CLIENT AND MAY BE SUBJECT TO CHANGE IN THE FUTURE. FOR GUIDANCE, SEEK PROFESSIONAL ADVICE.
THE VALUE OF YOUR INVESTMENTS CAN GO DOWN AS WELL AS UP, AND YOU MAY GET BACK LESS THAN YOU INVESTED.