How are FX Markets affected by political and central bank events?

HOW ARE FX MARKETS AFFECTED BY POLITICAL AND CENTRAL BANK EVENTS?

• How do currency markets adapt to variations in monetary and fiscal policy?
• What is the rationale behind the Mundell-Fleming model and how does it relate to FX trading?
• How have USD, EUR and CAD been affected by policy actions from the Fed, ECB and BOC?

MARKETS HAVE PASSED THE POLITICAL EVENT HORIZON

For foreign exchange ("forex" or "FX") traders, the perpetual backdrop of politics presents an inescapable abyss. Conventional media gets swamped with punditry, while social media gets drowned in puns. Irrespective of the asset class being traded, even a solitary tweet from a politician can send shockwaves, impacting not only currencies but also bonds, commodities, and equities.

Amidst this increasingly turbulent landscape, traders seek a coherent framework to decode information and comprehend political developments as they unfold. After all, political actions can metamorphose into policies over time with persistent effort. Therefore, FX traders necessitate a method to interpret information and political events while considering potential changes in fiscal policy and how these changes might reverberate throughout their portfolios.

Nonetheless, market participants must pay heed to more than just fiscal policy. With central banks gaining substantial ground during the Great Recession and its aftermath, monetary policy emerges as an enduring and potent force shaping markets. Consequently, FX traders require a viable framework to analyze both fiscal and monetary policies in unison.

ECONOMISTS HAVE A SOLUTION BEYOND THE IS-ML MODEL

Fortunately, one such framework exists: the IS-LM-BP model, colloquially known as the Mundell-Fleming model. This powerful framework allows FX traders to analyze how changes in fiscal policy (such as alterations in taxes or government spending) and monetary policy (such as adjustments in interest rates) interact to produce various market outcomes.

Before we delve into the intricacies of the framework, let's explore a bit of background history on the Mundell-Fleming model.

Mundell-Fleming serves as an extension of the IS-LM model, which is an equilibrium model used by economists to examine the relationship between interest rates (the real interest rate denoted as "i" on the vertical axis of the chart below) and economic growth (real gross domestic product denoted as "Y" on the horizontal axis).

IS-LM Curve – Interest Rates and Economic Growth (Chart 1)

Without delving excessively into the academic intricacies, there are two key insights from the IS-LM model that seamlessly translate into comprehending the Mundell-Fleming model.

Firstly, the downward-sloping IS curve illustrates that as interest rates decline, economic activity ascends. This seems intuitive: greater credit availability fosters flourishing economic endeavors.

Secondly, the upward-sloping LM curve reveals that as economic activity escalates, interest rates also rise. This, too, is intuitive: heightened economic activity stimulates inflation and triggers higher bond yields in return.

THE IS-LM MODEL IN INAPPROPRIATE FOR MODERN ECONOMIES

The IS-LM model falls short for traders due to its inadequate representation of the complexities arising from the interconnectedness and interdependence of open economies in a globalized world. This foundational concept, while essential in its time, fails to capture the intricacies and dynamics of modern international trade, rendering it insufficient for informed decision-making in contemporary financial markets.

In the context of a rapidly evolving global economy, where cross-border transactions, capital flows, and foreign trade play pivotal roles, the traditional IS-LM model's closed economy assumption becomes a limiting factor. Traders, who operate in a diverse and interconnected marketplace, require a more comprehensive framework that accounts for the interactions between countries and their respective economic policies.

Moreover, the classic IS-LM model focuses primarily on the goods and money markets within a single country, neglecting the influence of international trade, foreign exchange rates, and global supply chains. For traders, these factors are critical in understanding market dynamics, hedging risks, and making informed investment decisions.

To address these deficiencies, a more nuanced and sophisticated approach is needed, incorporating principles from international economics, open-economy macroeconomics, and global finance. Models like the Mundell-Fleming model, which integrates international capital mobility and exchange rate dynamics, can better capture the complexities of open economies and their interactions on the world stage.

Furthermore, embracing a broader range of economic indicators and incorporating real-world data into the analysis is essential for traders seeking a comprehensive understanding of the ever-changing global economic landscape. This data-driven approach allows traders to assess market trends, anticipate shocks, and respond effectively to various economic scenarios.

In conclusion, while the IS-LM model laid the groundwork for understanding the basics of macroeconomics and supply-demand interactions, it is no longer sufficient to meet the needs of traders in a globalized world. To navigate the complexities of today's interconnected markets successfully, traders must adopt a more comprehensive framework that embraces the realities of open economies and takes into account the multitude of factors influencing international trade and finance.

THE MUNDELL-FLEMING MODEL WORKS BETTER FOR OPEN ECONOMIES

In the early-1960s, economists Robert Mundell and J. Marcus Fleming each contributed enhancements to the incomplete IS-LM model. Developed independently but later integrated into one unified idea, the IS-LM-BP model incorporates capital flow, introducing two distinct capital flow constraints.

High capital mobility characterizes developed countries and their currencies (e.g., the US, UK, Eurozone, Japan, etc.), whereas low capital mobility typifies emerging markets and their currencies (e.g., Brazil, China, South Africa, Turkey, etc.).

For the purposes of this discussion, we will focus solely on high capital mobility economies and strive to establish a framework for understanding how diverse fiscal and monetary policy mixes influence major currencies like the US Dollar, Euro, British Pound, and Japanese Yen.

In a subsequent report, we will explore the implications of the Mundell-Fleming model from the perspective of low capital mobility economies, analyzing the impact of policy changes on emerging market currencies.

DIFFERENT POLICY MIXES LEAD TO DIVERGENT REACTIONS IN MARKETS

For high capital mobility economies, there exist four distinct sets of policy adjustments that can elicit a response in foreign exchange (FX) markets. These scenarios are as follows:

1. When fiscal policy is already expansionary while monetary policy becomes more restrictive ("tightening"), it tends to have a bullish effect on the local currency.

2. When fiscal policy is already restrictive while monetary policy becomes more expansionary ("loosening"), it tends to have a bearish effect on the local currency.

3. When monetary policy is already expansionary ("loosening") and fiscal policy becomes more restrictive, it tends to have a bearish effect on the local currency.

4. When monetary policy is already restrictive ("tightening") and fiscal policy becomes more expansionary, it tends to have a bullish effect on the local currency.

It is crucial to acknowledge that for an economy like the United States and a currency like the US Dollar, when fiscal and monetary policies move in the same direction, the impact on the currency can often be ambiguous.

In other words, in the Mundell-Fleming model's context, when both fiscal and monetary policies are either expansionary or restrictive, the currency is less likely to experience a significant directional shift in the near future.

Instead, armed with this understanding, traders anticipating a period of trendless oscillation in a specific currency may be motivated to forgo momentum- and trend-based strategies, opting for an approach optimized for range-bound conditions.

Here are four instances in the previous decade from diverse high capital mobility economies across the globe that exemplify how employing the Mundell-Fleming model as a foundation for comprehending politics and central banks could have provided a trader with a distinctive analytical advantage.

SCENARIO 1 - FISCAL POLICY LOOSE, MONETARY POLICY BECOMES TIGHTER

Scenario 1: DXY, 10-Year Bond Yields Rise, S&P500 Futures Fall (Chart 2)

In this scenario, the US Dollar Index (DXY) and 10-Year Bond Yields are both expected to rise, while S&P 500 Futures are projected to fall. The combination of factors driving this outlook includes the Federal Reserve's reduced probability of a rate cut, based on Chairman Jerome Powell's comments suggesting that soft inflationary pressure was transitory and the economy's outlook was solid. This less dovish stance surprised the markets and led to a decline in the likelihood of a rate cut, supporting the US Dollar.

Moreover, the Congressional Budget Office's forecast of an increase in the deficit over the next three years, combined with a speculation of a bipartisan fiscal stimulus plan, particularly the US$2 trillion infrastructure program, implies expansionary fiscal policy. This fiscal stimulus plan is expected to create jobs and boost inflation, which could prompt the Federal Reserve to raise interest rates to manage the growing economic activity.

As a result of this combination of factors, investors are likely to favor the US Dollar as it is perceived as a safe-haven currency amidst the tightening monetary policy and potential economic growth. Consequently, the DXY (US Dollar Index) is projected to appreciate by 6.2 percent against its major currency counterparts over the subsequent four months. Additionally, rising bond yields may attract investors seeking higher returns, leading to a potential decline in S&P 500 Futures as some funds shift away from equities to fixed-income securities.

SCENARIO 2 - FISCAL POLICY TIGHT, MONETARY POLICY BECOMES LOOSER

Scenario 2: Euro Sighs Relief – Sovereign Bond Yields Fall as Insolvency Fears are Quelled (Chart 3)

In the aftermath of the global financial crisis in 2008 and the subsequent Great Recession, the Mediterranean economies faced significant destabilization. This led to concerns about a potential region-wide sovereign debt crisis, particularly in Italy, Spain, and Greece, as their bond yields surged to alarming levels.

Investors grew increasingly apprehensive about the ability of these governments to repay their debts, leading to demands for higher yields to compensate for the perceived higher risk of default. Consequently, the Euro endured considerable turmoil, with doubts arising about its continued existence if a member state were to exit the Eurozone due to the crisis.

However, on July 26, 2012, a historic moment occurred in financial history when Mario Draghi, the President of the European Central Bank (ECB), delivered a crucial speech in London. He asserted that the ECB was fully prepared to take any necessary actions to safeguard the Euro, confidently stating, "it will be enough." This statement had a calming effect on European bond markets, effectively lowering yields.

To further mitigate stress in sovereign debt markets and provide relief to struggling Eurozone governments, the ECB introduced a bond-buying program known as "Outright Monetary Transactions" (OMT). While the OMT program was never utilized, its mere existence helped pacify anxious investors.

During this period, several troubled Euro area states also implemented austerity measures to stabilize their government finances. These measures aimed to restore confidence and reduce concerns about the solvency of these economies.

Initially, as worries about the Euro's collapse diminished, the currency appreciated against the US Dollar. However, over the following three years, the Euro experienced a substantial depreciation, losing over 13 percent of its value by March 2015. This depreciation can be attributed to various factors in the monetary and fiscal landscape of the Eurozone during that time.

Fiscal restraint in several Eurozone nations curtailed their governments' capacity to deliver monetary support, which could have bolstered employment opportunities and fostered inflation. Simultaneously, the central bank pursued a lenient monetary policy to mitigate the crisis. Consequently, this juxtaposition exerted downward pressure on the Euro compared to most of its principal currency counterparts.

SCENARIO 2: EURO, SOVEREIGN BOND YIELDS PLUMMET (CHART 4)

SCENARIO 3 - MONETARY POLICY LOOSE, FISCAL POLICY BECOMES TIGHTER

Inexplicably, during the nascent phase of the Great Recession, the Bank of Canada (BOC) implemented a drastic reduction in its benchmark interest rate from 1.50 to 0.25 percent, aiming to alleviate credit constraints, instill assurance, and rekindle economic expansion. Surprisingly, in direct contrast to expectations, the yield on 10-year Canadian government bonds exhibited an upward trajectory. This rally coincided precisely with the TSX stock index, Canada's benchmark, hitting its lowest point.

Scenario 3: USD/CAD, TSX, Canadian 2-Year Bond Yields (Chart 5)

Amidst the tumultuous financial landscape, the subsequent restoration of confidence and recovery in share prices was a pivotal moment. Investors exhibited a shifting preference, opting for riskier, higher-returning investments, such as stocks, over comparatively safer alternatives like bonds. This significant reallocation of capital sent yields soaring, despite the central bank's efforts towards monetary easing.

The Bank of Canada (BOC) responded by initiating rate hikes, eventually bringing them up to 1.00 percent, where they remained for the ensuing five years. Simultaneously, Prime Minister Stephen Harper took decisive action by implementing austerity measures to stabilize the government's finances amidst the global financial crisis.

However, the tables turned when the central bank reversed course and slashed rates back to 0.50 percent in July 2015. This monetary policy loosening, while necessary, had its repercussions. Both CAD and local bond yields suffered, as the capacity for fiscal policy support was constrained by the austerity measures.

Tragically, the decision to cut back government spending during such a precarious period proved costly for Mr. Harper, ultimately leading to his political downfall. In the 2015 general election, Justin Trudeau emerged victorious, taking over the reins as the new Prime Minister, amidst hopes of steering the nation towards a brighter future.

Scenario 3: Fluctuations in USD/CAD and Canada's 2-Year Bond Yields (Chart 6)

SCENARIO 4 - MONETARY POLICY TIGHTER, FISCAL POLICY BECOMES LOOSER

After Donald Trump's victory in the 2016 US presidential election, the political landscape and economic backdrop favored a bullish outlook for the US Dollar. With the Oval Office and both houses of Congress controlled by the Republican Party, the markets appeared to conclude that the potential for political volatility had diminished significantly.

This made the market-friendly fiscal measures proposed by candidate Trump during the election appear more likely to be implemented. These included tax cuts, deregulation, and infrastructure building. Investors seemed to overlook potential threats of launching trade wars against major trading partners like China and the Eurozone, at least for the time being. On the monetary side, central bank officials raised interest rates at the end of 2016 and were looking to hike rates again by at least 75 basis points throughout 2017.

With the prospect of fiscal expansion and monetary tightening on the horizon, the US Dollar rallied alongside local bond yields and equities. This was fueled by strengthened corporate earnings expectations and a positive outlook for broader economic performance, which also fueled expectations for firmer inflation and a hawkish response from the central bank.

Scenario 4) US Dollar Index (DXY), S&P 500 Futures, 10-Year Bond Yields (Chart 7)

SHORTCOMING OF MUNDELL-FLEMING MODEL

For many years, the IS-LM-BP or Mundell-Fleming model was a prevailing approach to assess the ramifications of policy changes in small open economies. Conversely, some economists argued that larger economies might not conform to the conventional "rules," leading to a preference for the IS-LM model.

However, in the last decade, new research has revealed that the IS-LM-BP framework actually provides a more accurate depiction of the contemporary globalized economy than the IS-LM model alone. Naturally, economists hold diverse opinions on this matter.

It is essential to recognize that there is no universally perfect analytical framework that can consistently offer insights, considering varying political contexts and monetary systems. Some events may trigger market reactions that defy immediate understanding or explanation.

Nevertheless, lacking a framework to interpret how politics and central banks influence FX markets would be imprudent. Employing the Mundell-Fleming model as a guide can assist traders in sifting through the daily news noise, enhancing their comprehension and practical response to information shaping FX market price trends.

Follow for more: TradNx