How Significant Is the Role of Politics and Central Banks in the Foreign Exchange Market?

What may be found on this page?

• HOW ARE THE MARKETS FOR FOREIGN EXCHANGE AFFECTED BY POLITICS AND CENTRAL BANKS?
• THE MARKET HAS MOVED BEYOND THE POLITICAL EVENT HORIZON AT THIS POINT
• BEYOND THE IS-LM MODEL, ECONOMISTS HAVE ANOTHER SOLUTION
• THE IS-LM MODEL SHOULD NOT BE USED TO STUDY MODERN ECONOMIC SYSTEMS
• WORKS BETTER FOR OPEN ECONOMIES IS THE MUNDELL-FLEMING MODEL
• A MIXTURE OF DIFFERENT POLICIES CAUSES DIFFERENT MARKET REACTIONS
• SCENARIO 1 – FISCAL POLICY IS LAX WHILE MONETARY POLICY TIGHTENS.
• SCENARIO 2: HAS A RESTRICTIVE FISCAL POLICY WHILE A MORE LAX MONETARY POLICY IS IMPLEMENTED
• SCENARIO 2: YIELDS ON EUROPEAN SOVEREIGN BONDS FALL (CHART 4)
• SCENARIO 3: MONETARY POLICY BECOMES MORE LAX WHILE FISCAL POLICY BECOMES MORE RESTRICTIVE
• FINANCIAL POLICY BECOMES LOOSER, MONETARY POLICY BECOMES TIGHTER
• LIMITATIONS OF THE MUNDELL-FLEMING MODEL

HOW ARE THE MARKETS FOR FOREIGN EXCHANGE AFFECTED BY POLITICS AND CENTRAL BANKS?

• How do changes in monetary policy and fiscal policy affect the currency markets?
• What exactly is the Mundell-Fleming model, and why must foreign exchange traders understand it?
• What effects have the policies of the Fed, ECB, and BOC had on the USD, EUR, and CAD, respectively?

THE MARKET HAS MOVED BEYOND THE POLITICAL EVENT HORIZON AT THIS POINT

For those who deal in foreign currency (also known as “forex” or “FX”), the continual background noise that politics provides is a black hole that cannot be avoided. Punditry is rampant in traditional media, while puns are everywhere on social media. It makes no difference what asset class you’re trading, either. In recent years, even a single tweet from a politician could impact not just currencies but also bonds, commodities, and stocks. This is true regardless of whatever asset class you’re trading.

Traders need a framework that allows them to assess information and comprehend political changes as they occur to succeed in an environment that is becoming more volatile, After all, politics may eventually become policy if enough time and effort are invested in the process, FX traders require a mechanism to analyze information and political events regarding how fiscal policy may change and how this could affect their portfolios, This is necessary so that they can achieve the goal mentioned above.

However, market players cannot just focus on fiscal policy alone; they must also consider other factors. Since the work of central banks acquired significant momentum during and after the Great Recession, monetary policy has had a significant impact that will endure long on markets. Traders in foreign exchange thus need a workable framework to examine both fiscal and monetary policy simultaneously.

BEYOND THE IS-LM MODEL, ECONOMISTS HAVE ANOTHER SOLUTION

The IS-LM-BP model, more often referred to as the Mundell-Fleming model, is one such framework that, fortunately, already exists, FX traders can assess how directional changes in fiscal policy (such as increases in taxes or government spending) and monetary policy (such as changes in interest rates) combine to generate various market outcomes thanks to this approach.

Before we go on to the framework, here is a brief overview of the Mundell-Fleming model’s origins and development.

The Mundell-Fleming model is an extension of the IS-LM model, which is itself an equilibrium model that economists use to examine the link between actual interest rates (shown as “i” on the vertical axis of the chart below) and actual gross domestic product (shown as “Y” on the horizontal axis).

IS-LM Curve, which depicts the relationship between interest rates and economic growth (Chart 1)

Two key insights can be gained from the IS-LM model that may be applied to comprehend the Mundell-Fleming model without delving too far down the rabbit hole of academia.

To begin, the fact that the IS curve slopes downward indicates that a higher degree of economic activity occurs when interest rates are reduced to a lower level, It should come as no surprise that credit availability will directly correlate to the level of economic activity fostered.

Second, the fact that the LM curve slopes upwards illustrates that an increase in economic activity results in an increase in interest rates, This is another thing that makes perfect sense: when economic activity is more remarkable, inflation results, and as a result, bond rates go up.

THE IS-LM MODEL SHOULD NOT BE USED TO STUDY MODERN ECONOMIC SYSTEMS

To what extent does the IS-LM model fail to meet the needs of traders? The IS-LM model is a fundamental idea that, when taken to its logical conclusion, results in the traditional supply-demand model known as AS-AD. However, the IS-LM model can only be used in economies that are either wholly self-sufficient or completely closed; a framework of this kind is unsuitable for a globalized society in which open economies that are interdependent on one another are the norm. To have a more comprehensive structure, we need to transcend beyond.

WORKS BETTER FOR OPEN ECONOMIES IS THE MUNDELL-FLEMING MODEL

At the beginning of the 1960s, two prominent economists, Robert Mundell, and J, Marcus Fleming, contributed individually to developing modifications to the unfinished IS-LM model, The IS-LM-BP model adds capital flow to the equation, Each model component was developed separately from the other, but finally, they were combined into a single coherent concept.

The IS-LM-BP model, often known as the Mundell-Fleming model, has not one but two distinct capital flow restrictions, Capital mobility may either be high or low, depending on the country, Different combinations of economic policy may cause the market to respond in various ways, depending on which one is used.

Generally, industrialized nations and their currencies (such as the United States of America, the United Kingdom, the Eurozone, Japan, etc.) have substantial capital mobility, On the other hand, money is not easily transferred between developing economies and their currencies, such as Brazil, China, South Africa, Turkey, and others.

For this discussion, we will examine the Mundell-Fleming model solely through the prism of high capital mobility economies, Consequently, we will establish a framework for understanding how various fiscal and monetary policy combinations impact significant currencies such as the United States Dollar, the Euro, the British Pound, and the Japanese Yen.

In a subsequent study, we will demonstrate the implications of the Mundell-Fleming model via the lens of countries with little capital mobility and the influence that policy changes have on emerging market currencies as a direct consequence of these implications.

A MIXTURE OF DIFFERENT POLICIES CAUSES DIFFERENT MARKET REACTIONS

Four broad kinds of policy moves might cause a response in the foreign exchange markets for countries with a significant degree of capital mobility, They are as follows:

• Scenario 1: Monetary policy becomes increasingly restrictive (“tightening”) while fiscal policy is already expansionary, resulting in a favorable local currency environment.
• Scenario 2: Fiscal policy is already restrictive, while monetary policy becomes more expansionary (also known as “loosening”), This is bearish for the local currency since both factors work against it.
• Scenario 3: Monetary policy is already expansionary (also known as “loosening”), while fiscal policy becomes more restrictive, which results in a bearish outlook for the local currency.
• Scenario 4: Monetary policy is already restrictive (sometimes known as “tightening”), while fiscal policy becomes more expansionary, which results in bullish sentiment for the local currency.

It is crucial to remember that if fiscal policy and monetary policy start going in the same direction for an economy like the United States and a currency like the US Dollar, there is sometimes an unclear influence on the currency.

When both the fiscal policy and the monetary policy of a country are expansionary, or when both the fiscal policy and the monetary policy of a country are restrictive, it is unlikely that that currency’s value will shift much very shortly, This is because the Mundell-Fleming model predicts such an outcome.

Instead, traders equipped with this knowledge and anticipating that a particular currency will undergo a period of trendless oscillation may be encouraged to forego momentum- and trend-based tactics in favor of an optimal method for range-bound circumstances.

Table 1 presents the framework proposed by the Mundell-Fleming Model for high-capital mobility economies.

Here are four instances from the previous decade from diverse, high capital mobility economies from across the globe that highlight how using the Mundell-Fleming model as a framework for understanding politics and central banks would have provided a trader an analytical advantage, All of these examples took place in high-mobility countries.

SCENARIO 1 – FISCAL POLICY IS LAX WHILE MONETARY POLICY TIGHTENS.

After the Federal Open Market Committee (FOMC) decided to keep interest rates in the range of 2.25-2.50 percent on May 2, 2019, the Chairman of the Federal Reserve Board, Jerome Powell, said that the relatively modest inflationary pressure in the economy was “transitory.” The message that can be drawn from this is that while the price increase has been slower than what officials at the central bank had hoped for, this will change soon.

Given that the underlying outlook was evaluated to be good, and the general trajectory of economic activity in the United States was viewed to be on a healthy path, the implication was that there was a decreased possibility of a reduction in interest rates occurring in the future, The Federal Reserve adopted a neutral tone, although it was far less dovish than the markets had predicted, After Powell’s remarks, the overnight index swaps for a Fed rate decrease by the end of the year dropped from 67.2 percent to 50.9 percent, which may explain why this happened.

In the meanwhile, the Congressional Budget Office (CBO) has projected that there will be a rise in the deficit over the next three years, which will coincide with the tightening cycle of the central bank, In addition, this occurred against the background of rumors and conjecture of a fiscal stimulus proposal that both parties would support, Late in April, influential leaders made public their proposals for an infrastructure initiative costing $2 trillion.

The combination of loosening monetary policy and more expansive government spending has created the conditions for a positive outlook for the US Dollar, It was anticipated that the fiscal package would lead to the creation of employment and an increase in inflation, which would encourage the Federal Reserve to hike interest rates, As it turned out, the value of the US Dollar increased by 6.2% versus the average of its major currency rivals during the succeeding four months.

Scenario 1: The Dollar Index and 10-Year Bond Yields Raise, While S&P 500 Futures Drop (Chart 2)

SCENARIO 2: HAS A RESTRICTIVE FISCAL POLICY, WHILE A MORE LAX MONETARY POLICY IS IMPLEMENTED.

The global financial crisis that began in 2008 and the Great Recession that followed sent global shockwaves and destabilized Mediterranean economies, As a result, concerns about a sovereign debt crisis affecting the whole area were exacerbated because bond rates in Italy, Spain, and Greece rose to unsettlingly high levels.

Investors started to lose faith in the capacity of these governments to make their debt payments, so they began to demand a higher return in exchange for taking on what looked to be a more significant risk of defaulting on their obligations, The Euro was in distress amidst the mayhem, and its value was harmed as questions were raised about whether or not it would continue to exist if the crisis resulted in the unprecedented exit of a member state from the Eurozone.

The President of the European Central Bank (ECB), Mario Draghi, gave a speech in London on July 26, 2012, which many people would perceive as the defining moment that preserved the single currency, This event is considered one of the most renowned events in finance history and is widely regarded as one of the most important, In his words, the European Central Bank is “ready to do whatever it takes to preserve the Euro.” This remark served to calm the bond markets in Europe and contributed to bringing rates back down to more reasonable levels, “And believe me,” he said, “it will be enough.”

In addition, the European Central Bank established a program known as OMT (“Outright Monetary Transactions”), designed to purchase bonds, Its purpose was to alleviate the pressure building up on sovereign debt markets and assist troubled governments in the Eurozone, Even though OMT was never put to use, the fact that it was available helped calm apprehensive investors, Simultaneously, several problematic governments in the Euro area undertook austerity measures to stabilize their government finances.

Although there was an initial increase in the value of the euro as fears about its impending demise subsided, the value of the euro gradually decreased in comparison to the value of the dollar over the subsequent three years. As of March 2015, it had already dropped more than 13 percent in value. The reason for this becomes quite apparent when one considers the monetary and fiscal systems.

Scenario 2: The Euro Breathes a Sigh of Relief and Yields on Sovereign Bonds Fall as Fears of Insolvency Are Alleviated (Chart 3)

The capacity of governments in many countries within the Eurozone to offer fiscal stimulus, which may have assisted in creating employment and contributed to an increase in inflation, was hindered by austerity measures, At the same time, the Federal Reserve was taking steps to relieve the crisis by loosening its monetary policies, Due to this combination, the Euro experienced downward pressure versus most of its key competitors.

SCENARIO 2: YIELDS ON EUROPEAN SOVEREIGN BONDS FALL (CHART 4).

SCENARIO 3: MONETARY POLICY BECOMES MORE LAX WHILE FISCAL POLICY BECOMES MORE RESTRICTIVE.

The Bank of Canada (BOC) reduced its benchmark interest rate from 1.50 percent to 0.25 percent in the early stages of the Great Recession to ease lending conditions, restore confidence, and revive economic development, The yield on 10-year Canadian government bonds started to climb, which is the opposite of what one would expect to happen, This upswing began roughly at the same time as the TSX Composite indicator, considered Canada’s most important stock market indicator, reached its lowest point.

Scenario 3: US Dollar/Canadian Dollar, Toronto Stock Exchange, and Yields on Canadian 2-Year Bonds (Chart 5)

The following restoration of trust and rise in share prices reflected investors’ changing preference for riskier, higher-returning assets (such as equities) over relatively safer alternatives (such as bonds). Despite the actions taken by the central bank to loosen monetary policy, rates rose as a result of the reallocation of capital. The BOC subsequently started a fresh round of rate hikes and eventually took them up to 1%, where they stayed unchanged for the succeeding five years after that point.

During this period of the global financial crisis, Prime Minister Stephen Harper put into place austerity measures to balance the finances of the government. After that, the central bank changed its mind and brought interest rates back down to 0.50 percent by July 2015. As a result, the relaxation of monetary policy and the restriction of the ability for fiscal policy assistance, local bond rates, and the Canadian dollar both had adverse effects. As it turns out, Mr. Harper’s decision to cut down on government expenditure during this challenging period ultimately led to his losing his position. After winning the general election in 2015, Justin Trudeau was able to unseat him and become the next Prime Minister of Canada.

Scenario 3: USD/CAD, Bond Yields for Canada’s 2-Year Maturity (Chart 6)

FINANCIAL POLICY BECOMES LOOSER, MONETARY POLICY BECOMES TIGHTER

Following the announcement that Donald Trump had been declared the winner of the election for president of the United States in 2016, the political climate and economic background encouraged an optimistic outlook for the US Dollar, As a result of the Republican Party’s dominance of the White House and both chambers of Congress, the financial markets seemed to have concluded that the potential for political unpredictability had been significantly diminished.

As a result, the fiscal policies more favorable to the market that candidate Trump advocated throughout the election seemed to have a greater chance of being enacted, These measures included tax reduction, deregulation, and increased investment in infrastructure, At least for now, investors seemed to disregard warnings that the United States may engage in a trade war with major trading partners such as China and the Eurozone, Concerning the monetary front, authorities from the central bank increased interest rates around the close of 2016 and planned to increase them again by at least 75 basis points during 2017.

The United States Dollar strengthened with local bond rates and equity prices as the potential for government spending increased, and monetary policy normalization became more apparent, This resulted from a rise in expectations for profits to be made by corporations, as well as an improvement in projections for the performance of the economy as a whole, These projections were buoyed by the prospect of higher inflation and, therefore, a more hawkish reaction from the central bank.

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

LIMITATIONS OF THE MUNDELL-FLEMING MODEL

The IS-LM-BP model, also known as the Mundell-Fleming model, was a method that was used for a significant amount of time as a method to quantify the effect of changes in policy for small open economies. The IS-LM model was chosen because many economists believe that sufficiently large economies may not operate by the “rules” that “normal” economies have to deal with. As a consequence of this, the IS-LM model was seen as superior

In the last ten years, fresh research has shown that the framework described in IS-LM-BP more accurately depicts the condition of the modern globalized economy than the IS-LM model does on its own. Various economists hold a wide range of perspectives on this topic.

In the end, there is no “Holy Grail” analytical framework that will always provide the appropriate insight, independent of the political environment or the condition of the monetary system, This is true even though there is no “Holy Grail.” Sometimes, market responses to events cannot be easily understood or explained, These occasions may be relatively common.

On the other hand, it would be foolish not to have a framework for how to understand the role that politics and central banks play in driving currency markets. When traders use the Mundell-Fleming model as a guide, it may help them filter out the noise of the day-to-day news cycle, which in turn helps them better comprehend and realistically respond to information that is affecting price patterns in the foreign exchange market.