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How does politics affect the Forex market and currency valuations?
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How does politics affect the Forex market and currency valuations?

created Forex Club2 May 2024

Forex is a global market where individuals, financial institutions, organizations, businesses and governments from all corners of the world exchange currencies. The daily trading volume in the forex market exceeds $6 trillion according to recent statistics, making it the largest and most liquid market in the world. Due to the global nature of trading, various factors influence the FX market. They can be broadly divided into two categories:

  • Macroeconomic factors: include the interest rate, inflation, trade balance, balance of payments and public debt.
  • Non-macroeconomic factors: include politics (diplomatic relations, elections, assassinations), major events (Olympics, pandemics), natural disasters, acts of terrorism, speculation and sentiment.

Do political factors have a greater impact on the Forex market than economic publications?

Typically, macroeconomic factors related to a given country have a greater significant and direct impact on its local currency. However, their impact is usually short-lived. This is because experts from around the world use a mass of advanced indicators and analysis to predict economic releases. Moreover, there are indicators that show how good or bad the data may be.

Let's take an example NFP (non-farm payroll) report from the USA. This is the most important economic information on the market, published regularly every first Friday of the month. Days or even weeks before the premiere, experts from every corner of the world present their predictions about the NFP result. Moreover, the preliminary jobless claims report highlights the strength or weakness of another major NFP figure. Let's assume that despite all this, the report falls short or exceeds expectations. Thanks to technological progress, traders react extremely quickly to the report. Initially, there are usually large price fluctuations, but after a few hours of such high volatility, the market calms down again and waits for the next economic data release.


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How does politics affect the Forex market?

Although there are several factors that influence the volatility of currencies and cause significant fluctuations in their value, investors often ignore how policies can impact the FX market. Politics can cause great uncertainty among traders and investors around the world. This is because political events are usually:

  • Long lasting – weeks, months, even years (definitely more than a few hours!),
  • Largely unpredictable – due to the large number of variables at play,
  • Getting more countries involved – even elections in one country have consequences for allies and opponents.

Some geopolitical events, such as Trump's victory in the presidential election, the French election, the US-China trade war and Brexit, have caused prices in the currency market to fluctuate more than even the most important economic data released by a given country.

Political stability

Countries with a low risk of political uncertainty are more attractive for foreign entities to invest. For this reason, political stability increases demand for the national currency and has a significant impact on exchange rates. For example, Switzerland is known for its political stability, maintaining a neutral stance, and staying away from conflicts with other nations. For this reason, the Swiss franc enjoys safe haven status and is also used to hedge risk in other currencies.

On the other hand, protests, cooperatives and political chaos have a destabilizing effect on the economy and weaken the local currency. This reduces the demand for a given national currency and increases the risk of maintaining it.

Government involvement in the economy

The degree to which a government controls the economy can have a significant impact on the stability of a currency. Governments usually manage their currency very closely. However, given the increased mobility of capital in a highly globalized world, governments must take increasingly stronger measures to control the economy, resulting in greater uncertainty and therefore high volatility in the forex market.

Government fiscal policy

Fiscal policy covers a government's plans for spending over a specific period. The government collects taxes and takes on debt to finance various projects. Higher government spending stimulates economic growth because money flows into the economy, which fuels economic activity and is used to pay wages and buy other products. Therefore, an increase in government spending increases the value of a country's currency.

The benefits of increased government spending are short-lived if it is financed by higher public debt rather than tax collections. The increase in public debt reduces demand for the local currency and puts pressure on its exchange rate. Large public debt is also a sign of impending instability as there is a greater risk of default, which discourages foreign investors and reduces demand for the currency.

On the other hand, low public debt suggests a more fiscally responsible government and greater economic stability. For example, public debt Australia tends to remain low compared to other developed countries, which provides support for the Australian dollar.

Covid-19

The coronavirus pandemic is an extremely unique non-macroeconomic event. The closure of borders and the decline in labor inputs resulted in a decline in gross domestic product (CBA) most countries around the world. Waiting for lockdowns may have resulted in a short-term boost in retail sales and consumer spending, but long-term trends looked bleak. The financial services sector had to strengthen its risk management strategies, and the decline in bank lending was felt by the real estate market. All of these factors influence the foreign exchange market and highlighted the unique set of political conditions facing governments.

Elections

While these are regular events that take place in almost every country, certain elections attract more investor interest. In any election race, a lot of emphasis is placed on the party's economic policies and the potential impact they will have on the country's economy. In addition, the government has significant influence on diplomatic relations with other countries. For example, a government with diplomatic relations can sign trade agreements with other countries, which strengthens the economy and increases demand for the local currency. This is considered a positive indicator of economic health as it minimizes the risk of political turmoil.

Highly contested elections involving candidates with completely different economic and cross-border ideologies can create great uncertainty. This translates into high volatility on the forex market in the period preceding the election results. For example, the 2018 Italian elections resulted in significant volatility and a downward trend in the euro, given the prospects of a populist government and a possible clash with the EU. There is a belief that Donald Trump and Joe Biden offer drastically different visions for the US economy. A direct impact on Forex trading is inevitable as noticeably higher trading volumes than normal are expected for every currency pair, including the US Dollar.

Government monetary policy

In addition to fiscal policy, the government influences the monetary policy of the central bank. Even countries that support floating exchange rates try to control the demand and supply of money. A country's central bank influences the money supply through changes in interest rates. By lowering the interest rate, a country can lower the value of its currency in an attempt to make its exports more price competitive.

Increasing the money supply in the economy

The government may decide to print banknotes to increase the money supply. Such efforts are called quantitative easing and have become popular in the US and Europe method of combating the financial crisis of 2008.

During periods of economic slowdown or recession, governments can support the economy and even financial markets. For example, the US government injected $2020 trillion into the economy in March 2, and then received another $19 trillion package in May in response to the Covid-3 pandemic. That's because much of the funding was distributed to all American adults, and some was earmarked to increase unemployment benefits. Many people used these funds to speculate on the stock, forex and cryptocurrency markets. The government then provided funds to health care organizations and pharmaceutical companies to provide free virus testing and treatment and conduct vaccine research. Some of the funds were given to small businesses to cover payroll and overhead costs in an attempt to limit bankruptcies.

Generally speaking, political stability, friendly diplomatic relations and fiscal discipline are indicators of economic growth that help strengthen the value of a currency. On the other hand, political unrest, conflicts with other countries and poor fiscal decisions can have a detrimental effect on the domestic economy and its legal tender. A country's allies and enemies can also have a significant impact on the exchange rate. A strong ally can increase foreign investment in a given country, a strong enemy can increase the risk for investors.

Due to all of these factors, it is important for Forex traders to stay up to date with political news. Traders should focus on major global political events, such as the US elections, and incorporate them into their long-term trading strategy. More importantly, additional emphasis should be placed on news that affects the currencies in their portfolio. If a large percentage of an investor's portfolio was in the US dollar, they should be well informed about political and economic news regarding the United States. This includes awareness of the Dow Jones Index and significant political events such as the 2020 US election.

How do US-China politics affect the Forex market?

The US-China trade war is a double-edged sword for the forex market. Deteriorating diplomatic relations between the two countries are affecting their currencies. Added to this is the fact that the US-China conflict is related to trade, which has a much deeper impact Rynek forex.

The tug-of-war between the Trump administration and China began over issues including intellectual property theft, forced technology transfer, China restricting access to its market and preferential treatment for the Asian nation's state-owned enterprises.

By July 2018, the United States had imposed tariffs on $34 billion of Chinese imports. China hedged against this situation by devaluing the yuan to negate the impact of the tariffs. Currency devaluation is a common strategy adopted by countries struggling with a trade war. This is a logical response to aggressive tariffs and is not a new phenomenon.

Why is this logical? High tariffs imposed by country A on country B increase the price of products that country B exports to country A. This is a protectionist policy that makes country B's products less price competitive in country A's domestic market. In an attempt to combat this increase in price, Country B can resort to currency devaluation, which involves lowering the exchange rate between its local currency and the currency of Country A. Because Country B's currency is now cheaper, its exports to Country A become price competitive again.

Impact on the US dollar

The US dollar started 2018 on a downward trend, mainly due to growth in the world's other leading economies, especially Europe. The US dollar index, which measures the dollar's value against a basket of major currencies, fell to a low of 15 on February 88,59.

The beginning of the trade war with China has caused huge volatility in the US dollar exchange rate. The dollar then began an upward trend, although it remained volatile amid uncertainty over the consequences of the US-China trade war. The US Dollar Index reached its 2018 high on November 12, reaching 97,54 and ending the year at 96,17.

The US dollar strengthened in the first half of 2019. In fact, during the first six months of this year, the US dollar showed a clear upward trend on a monthly basis, supported by interest rate increases made by Federal Reserve, strong economic growth and a low unemployment rate.

The dollar continued to rise, albeit at a slower pace, over the next several months. On September 3, 2019, the US dollar index reached its highest level in two years and was very close to exceeding 100. Then came a period of escalating trade war tensions, which resulted in the weakening of the US dollar.

Impact on other currencies

China has stepped up its fight in the trade war by further devaluing its currency. In August 2019, the yuan fell almost 4% against the US dollar, the largest monthly decline in more than two decades. Geopolitical tensions have affected more than just the US dollar and Chinese yuan. This affected almost all currencies in the world. What made the impact more pronounced and widespread was the trade war between the world's two largest economies.

As China devalued its currency, other countries such as New Zealand and Thailand implemented monetary policies to weaken their currencies so that their exports remained price competitive. The Argentine peso, Brazilian real and Turkish lira also fell.

Latin American currencies were the most volatile because their economies are highly dependent on trade. Any information related to the conflict between Washington and Beijing caused large fluctuations in the prices of these currencies. Among the G-10 currencies, the Canadian dollar has shown the most volatility amid political tensions between the U.S. and China because it is a commodity currency. The Australian dollar did not lag far behind the Loonie in reaction to such news. This is mainly because the tensions have taken a toll on the economy of China, which is Australia's largest trading partner.

In December 2019, the US president said that a phase one trade deal with China would be signed in January 2020. Despite uncertainty over the details of such a deal, the pound, euro and other trade-sensitive currencies gained in value, sending the US dollar to its lowest level since six months. This was due to the increase in investors' risk appetite due to the prospect of easing political tensions between Washington and Beijing.

The currencies that have benefited most from geopolitical tensions are those that act as safe havens, namely the Swiss franc and the Japanese yen. As you can see, there is a direct correlation between politics and the forex market.

How does Brexit policy affect the Forex market?

Brexit, i.e. Great Britain's exit from the European Union, had a significant and long-lasting impact on the forex market. Below we provide a look at the various Brexit events and their impact on the British Pound, which has led to an unprecedented downward spiral that has lasted over three years. Here's how it happened:

On June 23, 2016, the UK voted to leave the EU. Theresa May formed a government in July, after which withdrawal negotiations began. This sent shockwaves through the markets, causing panic and sell-offs. The global stock market lost $2 trillion within 24 hours of the results being announced. The British pound fell and the pair GBP / USD lost almost 8%, marking the largest single-day sell-off since World War II.

The pound lost 15% against the euro and 17% against the Australian dollar. As uncertainty persisted, the pound continued to fall over the next six months, losing almost 20% against the US dollar. On March 29, 2017, when Prime Minister May triggered Article 50, which set the date for Britain's formal exit from the EU exactly two years later, the pound fell sharply. The GBP/USD pair reached a low of 1,2441 that day.

The Brexit Withdrawal Agreement was published on 14 November 2018 and subsequently approved by EU member states. The prospect of a no-deal Brexit made headlines, sending the market into a frenzy. The pound lost around 2% against the US dollar and euro.

As the agreed Brexit date (March 29, 2019) approached, the pound became highly volatile, although the overall trend continued to be down. On April 10, the UK and the EU27 agreed to extend the Brexit date to October 31, 2019.

In May 2019, the pound began to recover. This was due to another political event that played a key role in supporting the pound against both the US dollar and the euro. Theresa May has resigned as leader of the Conservative Party, making way for her seat Boris Johnson as prime minister. Although markets initially welcomed Prime Minister Johnson with a rise in the British pound, investors soon became fearful as his rhetoric on Brexit intensified and hopes for the UK reaching a deal with the EU faded. The pound fell on July 28, hitting a 28-month low of $1,2242. The pound sterling also depreciated against the euro, reaching €1,1004.

Until October 2019, the pound remained largely in consolidation as EU leaders approved British Prime Minister Boris Johnson's Brexit deal and set the agreement's entry into force on November 1. However, the British currency rose in December to its highest level in over a year following news of Boris Johnson's election victory.

Finally, on January 31, 2020, the UK left the EU and the British Pound ended the month with significant gains against other major currencies. While this should have been a stabilizing factor, volatility persisted. Months after Brexit, the UK and the EU were still negotiating an agreement on major issues "there was neither a breakdown nor a breakthrough". In fact, in March 2020, the GBP/USD pair recorded a new low around 1,16.

Brexit is a great example of how politics can impact the forex market and how significant and long-lasting the impact it has.

Summation

A country's political landscape and its relationship with the rest of the world play a key role in the country's overall economic health and prospects, and therefore its currency. Even Forex traders who use technical analysis to make decisions must consider monitoring political news and staying aware of major events to stay informed about the long-term situation. The need to stay up to date with politics is even greater during periods of economic slowdown, when its ability to cause market fluctuations increases.

Politics can have a more significant impact on the forex market than economic factors. This is because political events are not one-off events and their effects are often more difficult to predict than economic publications. Moreover, political ideologies can influence how closely a government controls the economy and influence growth through its fiscal and monetary policies.

Generally speaking, the forex market prefers periods of peace within a country and a lack of conflict between nations. The value of the currency is supported by the pro-growth and fiscal responsibility of the country's government. Political events and uncertainty lead to volatility, which many Forex traders view as favorable. They consider volatility as a tool for creating trading opportunities and try to use it in their trading strategies.


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