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FX Markets Displaying Clear Shift From Economic To Political Drivers


New Theme Developing

Looking back over the year it’s clear that one of the key themes that’s developed is that of FX markets being increasingly shaped by political rather than economic factors. The dominant example of this dynamic in play currently is the way that markets have responded in the run up to, and in immediate response to, the US elections.

What is it that has caused this shift in focus from economic to political factors? The main reasons appear to be:

That QE has stifled the bond markets
That QE has distorted equity markets
Zero and negative interest rate regimes

QE’s Effect On Bond Markets

Looking first at all at how QE has stifled the bond markets; the central bank purchase of Government bonds has subdued one of the traditional financial market channels. Historically traders labeled “bond vigilantes” would punish governments for poor fiscal policy, however with bond markets now dominated by central bank buying, there is little scope for this traditional bond market reaction. The suppression of this activity has led to structurally lower US Treasury volatility in the now QE dominated environment. Consequently, FX markets have now become the place for vigilantes to punish the weak and reward the strong.
QE’s Effect on Equity Markets

In terms of equity markets this same flow of money has kept markets supported even during times of unusually slow economic growth and weak earnings growth. Investors looking for yield have driven corporates to issue higher dividends or engage in buybacks with spare capital instead of using it for productive investment. Hence, because FX markets are less directly distorted by QE, they have become the preferred instrument for trading political developments.
Effect Of Low Rate Regimes On FX

Zero and negative interest rate regimes have fundamentally altered what once was the at the very core of FX markets. Monetary policy was a clear cyclical driver for FX markets. Now, however with many central banks at the zero or negative bound, interest range changes are having a diminishing effect on currency markets, which no longer respond the way they once did. As this historically core driver of FX moves becomes less important, reactions to political events are becoming more acute.

This has created a difficult environment for many banks and institutions whose analysts have lost their framework for forecasting currency moves. The traditional relationship between growth, inflation and rates have become distorted. The difficulty with the shifting of emphasis from economics to politics is that politics is incredibly unpredictable as proven by recent events such as Brexit and the Trump elections where both bookmakers and poll makers were caught on the wrong side.
Brexit Highlights Clear Shift

The market reaction to Brexit is perhaps the best example of political drivers taking over. GBO had typically been a cyclically driven currency responding to interest rate differentials. However, from the turn of the year, the issue of the UK’s EU membership referendum started to take center stage and exposed structural imbalances in the UK economy.

The decision to leave the EU has left GBP vulnerable to further political uncertainty. The decision also creates challenges in terms of funding the UK’s large current account deficit as foreign investors will be less inclined to purchase UK assets amidst heightened political uncertainty. Looking ahead, the Brexit negotiation is unlikely to be straightforward. There is plenty of room for further volatility, as demonstrated recent by the market’s response to news that the UK High Court ruled in favour of parliamentary approval being needed for the government to formally trigger article 50.

With FX markets now clearly demonstrating an emphasis on political events over economic inputs, there is much more ambiguity in outlooks and a much greater risk of volatility. The next key events for traders will be the Italian Constitutional Reform Referendum on December 4th followed by the French and German elections after the turn of the year.

Wednesday, 16 Nov, 2016 / 1:30

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Source : https://www.orbex.com/blog/2016/11/fx-markets-displaying-clear-shift-economic-political-drivers/

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