How Do Politics and Central Banks Impact FX Markets?

How Do Politics and Central Banks Impact FX Markets

• How do monetary and fiscal policies affect the foreign exchange market?
  What is the Mundell-Fleming Model and why is it important for Forex traders?
  How do Fed, ECB and Bank of Canada policies affect the USD, EUR and CAD?

MARKETS HAVE PASSED THE POLITICAL EVENT HORIZON

For foreign exchange (“Forex” or “FX”) traders, the constant political background noise is an inevitable black hole. Whereas traditional media is drowning in puns, social media is drowning in puns. It also doesn’t matter what asset class you trade. In recent years, even a single tweet from a politician can drive not just currencies but bonds, commodities and stocks.

In an increasingly difficult environment, traders need a framework to interpret information and understand political developments that are taking place. After all, with enough time and effort, politics can become politics. To do this, forex traders need a way to interpret information and policy developments related to how fiscal policy may change and how this may affect their portfolios.

However, market participants are not only concerned with fiscal policy.

With central bank activity gaining significant traction during and after the Great Recession, monetary policy appears to have had a strong and lasting impact on markets. Therefore, Forex traders need a workable framework to analyze both fiscal and monetary policy.

ECONOMISTS HAVE A SOLUTION BEYOND THE IS-LM MODEL

Fortunately, such a framework exists: the IS-LM-BP model, or the Mundell-Fleming model as it is commonly known. Through this framework, foreign exchange traders can analyze how directional changes in fiscal policy (such as changes in taxes or government spending) and monetary policy (such as changes in interest rates) interact to produce various market outcomes.

Before we dive into the framework, a little background history of the Mundell-Fleming model.

Mundell-Fleming is an extension of IS-LM, which itself is used by economists to calculate interest rates (real interest rates, “i” on the vertical axis in the graph below) and economic growth (real GDP, “Y” on the horizontal axis) ).

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

Without going too far down the academic rabbit hole, there are two takeaways of the IS-LM model that carryover into understanding the Mundell-Fleming model.

First, that the downward sloping IS curve demonstrates that as the level of interest rates fall, the level of economic activity rises. This is intuitive: the more readily credit is available, the more economic activity will flourish.

Second, the upward sloping LM curve demonstrates that as economic activity rises, the level of interest rates rise too. This is also intuitive: stronger economic activity provokes inflation and higher bond yields in response.

THE IS-LM MODEL IS INAPPROPRIATE FOR MODERN ECONOMIES

Without going too far down the academic rabbit hole, the IS-LM model has two points that translate to understanding the Mundell-Fleming model.

First, the downward sloping IS curve shows that when interest rates fall, the level of economic activity rises. It’s intuitive: the easier credit is available, the more economic activity flourishes.

Second, a rising LM curve indicates that interest rates rise as economic activity increases. It’s also intuitive: stronger economic activity triggers inflation and a corresponding increase in bond yields.

THE MUNDELL-FLEMING MODEL WORKS BETTER FOR OPEN ECONOMIES

In the early 1960s, economists Robert Mundell and J. Marcus Fleming each proposed improvements to the incomplete IS-LM model. The IS-LM-BP model was developed independently but eventually synthesized into a unified idea that incorporates cash flow into the equation.

There are two different cash flow constraints in IS-LM-BP or Mundell-Fleming models. Capital mobility is high or low across countries. Depending on the situation, different policy mixes lead to different market reactions.

As a rule of thumb, developed countries and their currencies (eg US, UK, Eurozone, Japan, etc.) have high capital mobility. On the other hand, emerging markets and their currencies (eg Brazil, China, South Africa, Turkey, etc.) have lower capital liquidity.

For the sake of discussion, we will study the Mundell-Fleming model only through the perspective of economies with high capital mobility, thus trying to provide a framework for understanding how different fiscal and monetary policy mixes affect major currencies such as the US dollar, EUR, GBP and JPY.

In a follow-up report, we will demonstrate the impact of the Mundell-Fleming model through the lens of economies with illiquid capital and the subsequent impact of policy changes on emerging market currencies.

DIFFERENT POLICY MIXES LEAD TO DIVERGENT REACTIONS IN MARKETS

For economies with high capital liquidity, there are actually four different types of policy changes that can elicit a reaction from the foreign exchange market. they are:

Scenario 1: Fiscal policy has expanded + monetary policy has become more restrictive (“tightening”) = bullish on local currency
Scenario 2: Fiscal policy is already restrictive + monetary policy becomes more expansionary (“easy”) = bearish on local currency
Scenario 3: Monetary policy has expanded (“easy”) + fiscal policy has become tighter = bearish local currency
Scenario 4: Monetary policy is already restrictive (“tightening”) + fiscal policy becomes more expansionary = local currency bullish

It is important to note that for an economy like the US and a currency like the US dollar, whenever fiscal and monetary policy start to move in the same direction, there tends to be a vague effect on the currency.

In other words, viewed in the context of the Mundell-Fleming model, if both fiscal and monetary policy are expansionary, or both fiscal and monetary policy are tightening, it is unlikely that the currency will experience in the near future Significant directional change.

Conversely, traders who predict a period of trend-free movement in a particular currency based on this insight may be encouraged to shelve momentum and trend-based strategies in favor of approaches optimized for range bound conditions.

Mundell-Fleming Model Framework for High Capital Liquidity Economies (Table 1)

Below are four examples from the past decade from different economies with high global capital mobility that illustrate how using the Mundell-Fleming model as a framework for understanding politics and central banking can give traders an analytical advantage.

Scenario 1 – FISCAL POLICY LOOSE; MONETARY POLICY BECOMES TIGHTER

On May 2, 2019, following the FOMC’s decision to keep interest rates in the 2.25-2.50 range, Federal Reserve Chairman Jerome Powell said relatively weak inflationary pressures in the economy were “temporary.” The implication behind this is that while price growth is lower than central bankers expected, it will soon accelerate.

The implied message at the time was that future rate cuts were less likely, as the fundamental outlook was considered solid and the overall U.S. economy was on a healthy path. The neutral tone adopted by the Fed was less dovish than the market had expected. That could explain why overnight index swaps for Fed rate cuts fell from 67.2% to 50.9% at the end of the year following Powell’s comments.

Meanwhile, the Congressional Budget Office (CBO) forecasts an increase in deficits over the next three years, overlapping with the central bank’s tightening cycle.

Scenario 2 – FISCAL POLICY TIGHT; MONETARY POLICY BECOMES LOOSER

The 2008 global financial crisis and the ensuing Great Recession spread around the world, destabilizing the Mediterranean region. That has raised fears of a regional sovereign debt crisis as bond yields in Italy, Spain and Greece climbed to worrisome levels.

Investors began to lose confidence in the ability of these governments to service their debts and demanded higher rates of return to take on what appeared to be a higher risk of default. The euro has been battered in the chaos, and doubts about its existence will surface if the crisis forces a member state to exit the bloc in an unprecedented manner.

On July 26, 2012, European Central Bank (ECB) President Mario Draghi spoke in London in one of the most famous moments in financial history, seen by many as a pivotal moment in the rescue of the single currency.

He said the ECB was “ready to do whatever it takes to protect the euro. Trust me,” he added, “it will succeed.” That speech calmed European bond markets and helped push yields lower.

Austerity measures in many euro zone countries have limited the ability of their governments to provide fiscal stimulus that could help create jobs and boost inflation. Meanwhile, the central bank eased monetary policy to ease the crisis. As a result, this combination pushed the euro lower against most major currencies.

Scenario 2: Euro, Sovereign Bond Yields Fall (Chart 4)

Scenario 3 – MONETARY POLICY LOOSE; FISCAL POLICY BECOMES TIGHTER

In the early stages of the Great Recession, the Bank of Canada (BOC) cut its benchmark interest rate from 1.50% to 0.25% to ease credit conditions, restore confidence and revive economic growth. Contrary to expectations, the yield on the 10-year Canadian government bond started to rise. The rally came as Canada’s benchmark TSX bottomed.

Scenario 3: USD/CAD, TSX, Canadian 2-year bond yields (Figure 5)

The subsequent recovery in confidence and the rebound in stock prices reflected a shift in investor appetite for riskier, higher-yielding assets such as stocks, rather than relatively safer alternatives such as bonds. This reallocation of capital has resulted in higher yields despite central bank easing. The Bank of China then started raising rates again, raising the rate to 1.00% and keeping it there for the next five years.

During this period, Prime Minister Stephen Harper implemented austerity measures to stabilize government finances amid the global financial crisis. The central bank then reversed course, cutting interest rates to 0.50% by July 2015. Both the Canadian dollar and local bond yields were affected due to easing monetary policy and limited fiscal support capacity.

Coincidentally, cuts to government spending at this difficult time cost Mr Harper his job. Justin Trudeau succeeded him as prime minister after winning the 2015 election.

Scenario 3: USD/CAD, Canadian 2-year bond yield (Figure 6)

Scenario 4 – MONETARY POLICY TIGHT; FISCAL POLICY BECOMES LOOSER

The political landscape and economic backdrop favor a bullish outlook for the U.S. dollar after Donald Trump was declared the winner of the 2016 U.S. presidential election. With Republicans in control of the Oval Office and both houses of Congress, markets appear to be concluding that the room for political volatility has narrowed considerably.

That makes market-friendly fiscal measures proposed by candidate Trump during his campaign more likely. These include tax cuts, deregulation and infrastructure development. Investors appear to be ignoring the threat of a trade war against major trading partners such as China and the euro zone, at least for now. On the currency front, central bank officials raised rates in late 2016 and plan to raise rates again by at least 75 basis points in 2017.

The dollar rose alongside local bond yields and stocks as room for fiscal expansion and monetary tightening emerged. That’s because corporate earnings expectations have strengthened along with the broader outlook for economic output, the best driver of stronger inflation and a hawkish central bank response.

Scenario 4) U.S. dollar index (DXY), S&P 500 futures, 10-year bond yields (Figure 7)

LIMITATIONS OF THE MUNDELL-FLEMING MODEL

For many years, the IS-LM-BP or Mundell-Fleming model was a way to measure the impact of policy changes on small open economies. Conversely, many economists argue that a sufficiently large economy may not obey “rules” that “normal” economies have difficulty following, so the IS-LM model is considered preferable.

But over the past decade, new research has shown that the framework proposed in IS-LM-BP actually captures the state of the contemporary globalized economy better than the IS-LM model alone. Needless to say, opinions on the subject can be found within the sphere of economists.

At the end of the day, there is no analytical “holy grail” that provides the right insights every time, regardless of the political context or the state of the monetary system. Sometimes events trigger market reactions that cannot be easily understood or explained.

However, it would be irresponsible to not have a framework for how politics and central banks drive money markets. Using the Mundell-Fleming model as a guide can help traders filter out the noise of the daily news cycle and help them better understand and act on the information that affects price trends in the forex market.

— Written by CFA, Senior Currency Strategist Christopher Vecchio and Currency Analyst Dimitri Zabelin