Chapter 5
In This Chapter
Getting to know the main drivers of currency rates
Monitoring monetary policy and interest rates
Understanding official currency policies and intervention
Gauging risk sentiment and financial stability
The forex market is inherently a big-picture market. FX traders focus on
On a daily basis, currency traders have to sort through myriad economic reports, interpret the comments of political and financial officials from around the world, take stock of geopolitical developments, and assess movements in other financial markets. They do all this to help them determine what direction major currencies are likely to move.
Unfortunately, there is no set recipe for absorbing the daily flow of data and news to produce a clear-cut answer. Even if there were, many different market actors are pursuing their own interests, which may not be profit maximizing (see Chapter 3). Throw in market sentiment and future expectations, and you’re looking at market participants interpreting the same data and reaching different conclusions, or maybe reaching the same conclusions but at different times. In this chapter, we lay the foundation for building the framework to make sense of the many policy, data, and news inputs that affect the forex markets every day.
The first step in laying the foundation is to get a handle on interest rates and monetary policy, because they’re the final product of most of the other inputs. Unless you’re an economist or banker, following monetary policy developments probably is not one of your favorite hobbies. But if you’re going to actively trade in the forex market, you need to get a handle on monetary policy and interest rates. We’re not trying to turn you into an economist or an interest-rate analyst — we just want to give you the lowdown on how interest rates affect currencies.
In this chapter, we lay it all out so you can make sense of how it works, what goes into it, and how it’s communicated to the market. Later in the chapter, we get into the key elements of official currency policies and what happens when governments intervene in forex markets. Lastly, we take a look at the Great Financial Crisis of 2008–2009 (GFC) to see what lessons it holds for currency traders.
If the guiding principle in real estate is “location, location, location,” in currency trading it’s “interest rates, interest rates, interest rates.” The most significant overall determinant of a currency’s value relative to other currencies is the nature and direction of monetary policy set by a country’s central bank.
Perhaps the most important thing that a central bank does in relation to the forex market is set domestic interest rates, which also influence overall economic activity. Lower interest rates typically stimulate borrowing, investment, and consumption, while higher interest rates tend to reduce borrowing and increase saving over consumption.
Interest rates are important to currencies because they influence the direction of global capital flows and serve as benchmarks for what investors expect to earn investing in a particular country. This situation applies most directly to fixed income investing (bonds), which comprise the lion’s share of investments, but it also influences equity and other investment flows. All other things being equal, if you could invest in a government-backed bond that yields 6 percent or one that yields 2 percent, which would you choose? The one with the higher yield, of course. And that’s exactly what happens with currencies. Currencies with higher yields (higher interest rates) tend to go up, and currencies with lower yields (lower interest rates) tend to weaken.
And what drives interest rate expectations? The evolving economic outlook based on incoming data (we look at understanding and interpreting economic data in Chapters 6 and 7), economic assessments and guidance by monetary policymakers (see “Watching the central bankers” section later in this chapter), and a host of other economic, fiscal, and political developments (some of which we look at later in this chapter).
The outlook period, or the time frame in which markets are expecting interest rates to change, can span several months or quarters into the future. Depending on the economic circumstances and the outlook, markets may price-in interest rate changes a full year in advance, driving short term yields and currency levels in the process. Subsequent currency and yield fluctuations are based on incoming data and official guidance relative to the expectations markets have priced-in.
It’s important to remember that currencies always come in pairs. Rather than focusing solely on a particular currency’s interest rate level or outlook, forex markets tend to focus on the potential difference between two currencies’ prospective interest rate changes. If two major currencies’ central banks are both expected to be raising rates by the same amount in the future, there’s little reason for one to outperform the other. But if one is expected to raise rates higher or faster, there are grounds for one currency to strengthen relative to the other.
The difference between the interest rates of the two currencies, known as the interest-rate differential or spread, is the key rate to watch. An increasing or widening interest-rate differential will generally favor the higher-yielding currency, whereas a falling or narrowing interest-rate differential will tend to favor the lower-yielding currency.
Traders should monitor the interest-rate differentials among the major currencies by looking at the spreads between short-term government debt yields to spot shifts that may not otherwise be evident. Worth noting: The government bond market tends to price-in expected changes to interest rates, so it can give a more up-to-date view of what the market is thinking about rates compared to, say, the actual level of interest rates announced by a central bank. For example, U.S. 2-year yields may decline by 5 bps (basis points, or a hundredth of 1 percent) — not an unusual daily development. Around the same time, Australian 2-year yields may move 5 bps higher — again, nothing earth shattering there viewed on its own. But add the two together, and you’re looking at a 10 bps move between the two, and that’s something to pay attention to. If the same thing happens again the following day, now you’re looking at a 20 bps change in the differential, which is nearly equivalent to a typical 25 bps interest rate change from a central bank. You can be sure that if the Reserve Bank of Australia (RBA) unexpectedly raised interest rates by ¼ percent, or the Fed surprised everyone by cutting rates by ¼ percent, there would be some sharp swings in AUD/USD. The same holds true for changes in the interest-rate differentials, and they occur on a daily basis rather than the monthly meetings of most central banks.
The interest rate to focus on is not always just the nominal interest rate (the base interest rates you see, such as the yield on a bond). Markets focus on real interest rates (inflation-adjusted rates, which is the nominal interest rate minus the rate of inflation [usually consumer price index]). So even though a bond may carry a nominal yield of, say, 8.5 percent, if the annual rate of inflation in the country is 4.5 percent, the real yield on the bond is closer to 4 percent.
This phenomenon is most evident in emerging market economies facing hyperinflation. Even though nominal interest rates may be 20 percent, if the annual rate of inflation is 25 percent, the real yield is −5 percent. Hyperinflation and negative yields lead to capital flight. The result is extreme weakness in the domestic currency, even though nominal interest rates may be extremely high.
The same can be true with very low interest rates and deflation (negative inflation), such as what happened in Japan from 2000 to 2013. With interest rates at very low levels, eventually zero, and facing deflation, real Japanese yields were significantly higher than the nominal zero rates on offer. (Remember: If you subtract a negative number, it’s the same as adding that positive number.) As a result, the JPY experienced overall appreciation in this period despite very low nominal rates and abysmal economic prospects.
In the following sections, we introduce the key objectives of monetary policy, take you through the tool kits of monetary policymakers, and show you how to stay on top of the evolving interest rate picture.
Monetary policy is the set of policy actions that central banks use to achieve their legal mandates. Most central banks function under legislative mandates that focus on two basic objectives:
The primary lever of monetary policy is changes to benchmark interest rates, such as the federal funds rate in the United States or the refinance rate in the Eurozone. Changes in interest rates effectively amount to changes in the cost of money, where higher interest rates increase the cost of borrowing and lower interest rates reduce the cost of borrowing. The benchmark rates set by central banks apply to the nation’s banking system and determine the cost of borrowing between banks. Banks in turn adjust the interest rates they charge to firms and individual borrowers based on these benchmark rates, affecting domestic retail borrowing costs. Other tools in the monetary policy toolkit used by central bankers are
The main thrust (or bias, as markets call it) of monetary policy generally falls into two categories: expansionary or restrictive. An expansionary monetary policy aims to expand or stimulate economic growth, while a restrictive bias aims to slow economic growth, usually to fight off inflation.
Expansionary monetary policy (also known as accommodative or stimulative monetary policy) is typically achieved through lowering interest rates (that is, reducing the costs of borrowing in the hope of spurring investment and consumer spending). Cutting interest rates is also known as easing interest rates and is frequently summed up in the term easy monetary policy. Central banks can also increase the money supply — the overall quantity of money in the economy — which also works to lower borrowing costs. A reduction in the reserve requirement of banks frees up capital for lending, adding to the money supply and reducing borrowing costs as well.
An expansionary monetary policy is typically employed when economic growth is low, stagnant, or contracting, and unemployment is rising. Central banks of the major economies reacted to the fallout from the GFC and the global recession by slashing interest rates to historically low levels, near zero in the case of the United States, Switzerland, and Japan.
Restrictive monetary policy (also known as contractionary or tighter monetary policy) is achieved by raising, or “tightening,” interest rates. Higher interest rates increase the cost of borrowing, and work to reduce spending and investment with the aim of slowing economic growth and lowering inflation.
Central banks typically employ a tighter monetary policy when an economy is believed to be expanding too rapidly. The fear from the central banker’s perspective is that heightened demand coupled with the low cost of borrowing may lead to inflation beyond levels considered acceptable to the long-run health of an economy. With too much money chasing the same or too few goods, prices begin to rise, and inflation rears its ugly head. Rapid wage gains, for example, may lead to increased personal consumption, driving up the cost of all manner of retail products.
Changes in monetary policy usually involve many small shifts in interest rates, because central bankers are generally reluctant to shock an economy by adjusting interest rates too drastically. Even the potential for large interest rate changes could contribute to uncertainty among investors and businesses, potentially disrupting or delaying well-laid business plans, thereby harming the overall economy in the process and potentially boosting unemployment. Typical interest rate changes among the major central banks center on ¼ percent or 25 basis points (a basis point is 1/100th of 1 percent, or 0.01 percent), with 50 bps (or ½ percent) as the next most frequent rate adjustment.
The GFC and the accompanying global recession caused key central banks to slash rates rapidly, with cuts of 75 to 100 bps coming in rapid succession in some cases. Having cut benchmark rates to near zero, several major central banks felt compelled to undertake additional unconventional easing measures, such as QE, to support their economies.
Central banks can only directly influence the level of short term interest rates. Longer-term interest rates, the ones used by markets to set business and consumer lending rates, are determined by bond investors and are based on their views of growth, inflation, and creditworthiness. For example, the 10-year U.S. Treasury rate is the benchmark for U.S. mortgage rates.
When central banks cut their benchmark rates to near-zero levels, they were faced with the zero-lower bound of interest rates. To further support their economies, they sought to drive down longer-term lending rates through unconventional means, typically large-scale asset purchase programs where the central bank buys longer-term government bonds. (Remember, bond prices move inversely to bond yields — it’s just bond math. Buying longer-maturity bonds theoretically pushes bond prices higher and yields lower, hopefully sending consumer and business lending rates down in the process.)
Such large-scale asset purchase programs are frequently referred to as QE because the central bank is increasing the money supply, the quantity, by creating money to buy the bonds. In the United States, the Federal Reserve initiated two rounds of quantitative easing, while in the UK and Japan, the Bank of England and the Bank of Japan also undertook large-scale asset purchase programs. (Japan had also pursued QE repeatedly in the prior decade, well before the GFC.)
Currencies of countries pursuing such unconventional easing typically tend to weaken because such measures may drive down interest rates relative to other countries’ rates, at least while the program is in place. Some investors also view an increasing money supply as a currency negative (the greater the supply, the lower the value). But that doesn’t always hold true, especially if the extra money seeps out of the economy and into other markets, as it did in the United States in 2009.
A good example of this is when the U.S. Federal Reserve indicated in August 2010 it was considering undertaking a second round of QE, known as QE2. Initially, the USD weakened as the Fed was seen to be trying to lower rates further. But when the actual program was announced, the USD began to strengthen and U.S. yields moved higher. It might look like a case of “sell the rumor, buy the fact,” but it was more in response to U.S. data and the immediate outlook: The Fed was looking at QE2 in response to a slowdown in the summer of 2010, but by the time QE2 started in November 2010, U.S. data and the outlook had rebounded. And all that money the Fed was supposedly printing? It mostly ended up back at the Fed in the form of excess reserves held by the banking system, meaning it never entered the real economy.
If you’ve read this chapter from the beginning, you’ve probably gotten the impression that determining monetary policy is mostly an exercise in shades of gray rather than a simple black-and-white equation — and you’d be exactly right. But given the significance of monetary policy to currencies, currency traders devote a great deal of attention trying to divine the intentions of central bankers. This has not always been an easy task, but recent trends among central banks to improve the openness of communications with markets, frequently referred to as transparency, have made the process less of a guessing game.
Central bankers communicate with the markets in a number of ways, and their comments can provoke market reactions similar to major economic data releases — by that, we mean sharp initial price movements followed by continued volatility or a potential change in direction.
In the next section, we delve a bit deeper into how monetary policy is presented to financial markets by central bank officials. We also look at currency-specific policies and rhetoric. Sometimes, how a message is delivered or who delivers it is more important than the message itself. This is certainly true of monetary or currency policy comments from central bank or government finance officials.
Earlier in this chapter, we cover the various ways in which central bankers communicate their thinking to market participants (see the preceding section). But the process is far more nuanced and evolved than relying simply on official policy statements or speeches before the Rotary Club of Indianapolis. Central bankers are keenly aware that their comments have the ability to move, and potentially disrupt, financial markets all over the world. So they choose their words very carefully, leaving traders to act as interpreters. Before you start interpreting monetary policy statements and commentary, it’ll help to know the following.
The interest rate setting committees of central banks, frequently known as Monetary Policy Committees (MPCs) — the Fed’s FOMC is one of these — typically operate under a one-member/one-vote rule. But when it comes to delivering a message to the markets, the chairman or president of the central bank and its deputies hold far more sway than any other individual member. This is partly in deference to the central bank chief’s role as first among equals, but also because that person is frequently viewed as expressing the thinking of the entire committee. Central bankers strive for consensus in reaching their decisions, and who better to represent and present this view than the chairman or president?
In the case of the Fed, the FOMC is composed of 12 voting members consisting of the board of governors and a rotating slate of regional Federal Reserve Bank presidents each year. So when a Federal Reserve Bank president is set to speak, make sure you know whether she’s a voting member in the current year before acting on her comments.
Central bank officials are frequently a known commodity to market analysts and traders, either from past policy statements or from their academic or policy writings prior to becoming central bankers. Markets typically refer to central bankers in terms of being hawks or doves. A hawk is someone who generally favors an aggressive approach to fighting inflation and is not averse to raising rates even if it will hurt economic growth. A dove, on the other hand, is a central banker who tends to favor pro-growth and employment monetary policy, and is generally reluctant to tighten rates if it will hurt the economy. In short, hawks tend to be fixated on fighting inflation, and doves tend to stress growth and employment.
Don’t get us wrong: There are plenty of central bankers in the middle who can wear both hats (or feathers, in this instance). In those cases, the middle-of-the-roaders tend to reveal their hawkish or dovish leanings only at the extremes of the policy cycles.
Another major influence on currency values is government policies or official stances regarding the value of individual currencies. Some of the largest changes in currency values in recent decades have been brought on by official policies and multilateral agreements among the major industrialized economies. For instance, the Plaza Accord of 1985 stands out as a watershed in forex market history, ultimately resulting in a roughly 50 percent devaluation of the U.S. dollar over the course of the next two years.
National governments have a great deal at stake when it comes to the value of their currencies. After all, in a sense, a nation’s currency is the front door to its economy and financial markets. If the currency is viewed as unstable or too volatile, it’s tantamount to slamming the front door shut. And no major economy can afford to do that today.
In this section, we look at the major objectives of national currency policies, who sets them, and how they’re implemented.
Referring to official government thinking on currencies as a currency policy may be a mischaracterization. Instead, you may do better to think of it as a stance on particular currency values at a particular point in time.
Daily trading volumes in the forex market dwarf most national central bank currency reserve holdings. (Currency reserves are the accumulated stocks of international currencies held by central banks for use in market interventions and overall central bank reserve management.) Japan and China together have more than $2 trillion in central bank currency reserves. That may seem like a lot, but average currency trading volume in the global forex market is over $4 trillion per day. This means that even if national governments wanted to routinely manage the value of their national currency, they would be hard-pressed to overcome market forces if they were at odds with the official policy.
To summarize why governments are generally reluctant to get involved in trying to influence currency values, it comes down to the following:
In the next section, we look at the principal actors in each country or currency zone and what their recent actions on currencies suggest for their currency policy goals.
In the “Currency policy or currency stance?” section, earlier in this chapter, we list a number of reasons why national governments are reluctant to get involved in trying to influence the value of their currencies. Chief among these are the size and extent of the global forex market and the need for nations to reach agreement on whether adjustments are even needed. The Group of Seven (G7) used to be the main body where currency issues would be handled, but globalization has brought more economies to the table in the form of the Group of Twenty (G20). (We list the membership of the G7 and G20 at the end of Chapter 3.) With an even larger collection of competing national interests in the bigger G20, collective action on currencies seems less likely.
If governments had their way, they would probably prefer to see fixed exchange rates replace floating rates and avoid the subject entirely, but that’s not a realistic option for the foreseeable future. Confronted with the realities of forex markets, most government currency officials go to great lengths to avoid discussing currency values out of fear that their comments will be misinterpreted and lead to sharp exchange rate shifts. That fear was born out of experience, and today’s top currency officials are much more discreet than their predecessors just a few decades ago.
Responsibility for currency matters typically falls to the finance ministry or the central bank in the nations of the most heavily traded currencies. In the following sections, we take a look at who has responsibility for setting and implementing currency policies in the five major currencies and what their major motivations are.
The Department of the Treasury has the legal mandate for all currency matters, from printing the notes and minting the coins to ensuring the soundness of the U.S. dollar in international markets. The secretary of the Treasury is the primary spokesman for the U.S. dollar. The deputy Treasury secretary for international affairs is the hands-on Treasury official responsible for day-to-day currency matters.
The European Central Bank (ECB) is responsible for both monetary policy and currency matters under the agreement that created the single-currency Euro in 1999. The ECB’s governing council is the primary decision-making body; it’s composed of the presidents of the central banks of the participating nations, with the ECB president as the group’s chief policy maker and spokesman.
When the ECB needs to intervene in the market, it can do so by itself, along with the central banks of the member states on its behalf. In the EUR’s early years, global central banks intervened to prop up the newly formed currency; however, in recent years, there has been no official intervention in the EUR.
The ECB is primarily concerned with fighting inflation and seeks to achieve currency stability as a means of fostering long-term economic growth. Although Europe remains heavily export oriented, so extreme euro strength is a risk factor for the Eurozone economy, the ECB has been reluctant to intervene in the forex market so far.
The Ministry of Finance (MOF) is responsible for currency matters in Japan. The MOF is the most powerful government ministry in Japan and can wield more influence over economic affairs than even the Bank of Japan (BOJ), the central bank. The MOF devotes a great deal of attention to the value of the JPY. The primary day-to-day currency spokesman for the MOF is the vice minister for international affairs, but during periods of volatility the finance minister will frequently issue statements. It is not at all uncommon for the MOF to issue daily comments on the forex markets, particularly when JPY volatility increases. The MOF last ordered an intervention (see the next section) in September 2010 as the JPY was strengthening and USD/JPY was threatening to drop under the key 80.00 level as the Fed geared up for a second round of quantitative easing. The Japanese authorities, along with the major global central banks, also intervened in the JPY in the aftermath of the 2011 tsunami. The yen surged on the back of safe-haven flows, but the intervention was necessary to limit JPY strength and help rebuild the Japanese economy on the back of this tragic event.
The Chancellor of the Exchequer (treasury secretary or finance minister) is the individual responsible for the British pound’s fate. The governor of the Bank of England (BOE) also shares responsibility for the pound in a bit of a holdover arrangement from when the BOE became independent from the government in 1997.
The chancellor/BOE generally stays out of currency matters and appears most concerned with the pound’s exchange rate versus the euro, because the bulk of UK trade is conducted with the Eurozone.
The United Kingdom is closely aligned with European economies and would be a candidate to join the Eurozone single currency, but nationalism runs deep when it comes to getting rid of the pound. The standing government line is that no decision on joining the euro would be made without conducting a national referendum.
The Swiss National Bank (SNB) is charged with responsibility for the Swiss franc along with setting monetary policy. The SNB is most concerned with the Swiss franc’s exchange rate versus the euro, because nearly 80 percent of Swiss trade is conducted with Eurozone nations. The SNB has been known to speak up in opposition to CHF strength or weakness whenever the EUR/CHF exchange rate approaches extreme levels. During the Eurozone debt crisis in late 2009–2010, EUR weakened sharply against the CHF and prompted the SNB to intervene repeatedly to stem CHF strength, but without any success.
However, in 2011, the SNB took the unusual step of imposing a 1.20 peg on the EUR/CHF rate. At the time of writing, the SNB remains fully committed to this peg. Whenever the EUR/CHF rate approaches 1.20, the SNB is ready to intervene to stop it from falling below this level and limiting CHF strength. The market has taken the SNB at its word, and there have been only a handful of occasions since 2011 when the EUR/CHF rate has fallen below 1.20. This is an unusual situation — usually, intervention occurs only for a temporary period or in response to an economic crisis or national disaster.
In every big-bank currency trading room in major financial centers, there is a direct line to the open market trading desk of the central bank. When that line lights up, the whole dealing room erupts. That line is reserved for open market intervention by the central bank, and when it rings, it usually means only one thing: The central bank is intervening in the market.
Intervention refers to central banks buying or selling currencies in the open market to drive currency rates in a desired direction. Direct intervention in the market is usually taken only as a last resort. It also may be a stopgap measure to stabilize markets upset by extreme events, such as a stock market collapse or a natural disaster. When it’s not necessitated by emergency circumstances, markets are generally aware of the increasing risks of intervention.
In terms of actual open market intervention, there are several different forms it can take, all depending on which and how many central banks are participating. The more the merrier; better still, there’s strength in numbers.
Does intervention work? That is a question that frequently comes up when central banks get involved. The simple answer is an unequivocal “Yes, but … . ” Intervention is most effective when it’s backed by monetary policy moving in the same direction, such as expected higher interest rates to support a weak currency or easier monetary policy to weaken a strong one. Even then, interest rate changes are no guarantee that the intervention will be successful.
In the short run, the intervention may seem fruitless and counterproductive. This is especially the case with unilateral intervention. The market typically rejects the unilateral intervention and reverts to pushing the market in the direction opposed by the intervention. This situation can go on for weeks and months or — in the SNB’s case in 2010 — years, which can lead central banks to take even more dramatic action, such as imposing a currency peg. When it’s a joint or concerted intervention, the results are usually more immediate and successful.
The Great Financial Crisis of 2008–2009 triggered a massive global recession, the likes of which not seen since the Great Depression of the 1930s. As a result, major governments’ finances were thrown into disarray, as tax revenues plunged and spending was maintained or increased through fiscal stimulus. Suddenly the creditworthiness and financial stability of major national governments were being questioned by global markets.
The Eurozone debt crisis of 2009–2012 is the most obvious recent example, where bond investors fled Greek, Irish, Portuguese, and Cypriot government debt, raising borrowing costs to unaffordable levels and forcing those governments to seek a bailout from wealthier Eurozone members. From the start of the Greek debt crisis in November 2009 until a temporary bailout mechanism was established in May 2010, the euro weakened against the USD by more than 20 percent, and fell even more against other currencies.
And the fallout from the GFC is not confined to government debt. Major global banks lost trillions in the crisis, and some didn’t survive. In the aftermath of the financial crisis and the Eurozone debt crisis, some global banks remain extremely fragile and on government life support. In the case of European banks in particular, they hold around half of outstanding Eurozone government debt, meaning sovereign defaults or restructurings (a euphemism meaning investors don’t get back the full amount or payments are delayed) have the potential to cause additional massive losses to the banking sector, imperiling the Eurozone economy even further.
In the aftermath of the GFC, highly indebted European countries are certainly not alone in having investors question their financial stability. Debt levels in the United Kingdom, United States, and Japan are routinely cited as potential negatives, weighing on sentiment for those currencies from time to time. For the USD, its standing as the global reserve currency of choice is increasingly being called into question. And then there are the outliers, like Hungary, Iceland, and Dubai, small economies overall, but credit fears over their financial stability have a way of reverberating throughout global markets and sending risk sentiment (which we discuss later in this chapter) into a tailspin.
As part of your analysis of individual currencies, you need to be aware of the financial stability of the key currency countries. The metrics to keep in mind are
Just as with monetary policy and interest rate developments, financial stability evolves over a long time period. But there are day-to-day developments that impact the markets’ views of individual countries’ financial stability.
Geopolitics is nothing more than a fancy word used to describe what’s going on in the world at large. As it’s applied to the currency markets, geopolitics tends to focus on political, military/security, or natural disruptions to the global economy or individual regions or nations. Because currency markets are the conduits for international capital flows, they’re usually the first to react to international events, as global investors shift assets in response to geopolitical developments.
The United States tends to wield more influence on the world’s stage because it’s the largest national economy and the primary military superpower. In addition, the U.S. dollar is the largest global reserve currency and the de facto currency in many developing economies. Finally, with increasing globalization of trade and markets, the U.S. dollar frequently functions as a global risk barometer (see the next section for more on risk). For these reasons, the U.S. dollar tends to experience the greatest reaction in times of global turmoil or uncertainty, and the market tends to think in USD-positive and USD-negative terms, viewing all other currencies in contrast to the U.S. dollar. When geopolitical events are looking problematic, the USD tends to suffer, especially against safe havens like the yen. If the risks or tensions come down, the dollar may go up.
Elections in individual countries, including by-elections and legislative referenda, also fall under the geopolitical risk umbrella, especially when the outcome may lead to a change in government or economic policies. By-elections (ad hoc elections to fill individual legislative seats made vacant by death or resignation, for example) are typically seen as interim votes of confidence on the governing party. Depending on how near the next general election is, and on other economic factors, by-elections may have a greater effect on political sentiment.
In recent years, the concept of risk sentiment has taken hold as a way of expressing overall conditions across financial markets, including forex. Risk sentiment refers to investor behavior and whether investors are actively seeking returns by embracing riskier assets (risk seeking or risk appetite), or whether they’re seeking the safety of supposed more secure assets (risk averse or risk aversion). These two behavioral modes are frequently referred to as risk-on and risk-off, or risk-positive and risk-negative.
For currency traders, the risk environment can be a critical factor in driving currency rate movements. Part of the reason has to do with the interest rates of various major currencies. Hedge funds, commodity trading advisors (CTAs), and other leveraged speculators (see Chapter 3 for more on these guys) borrow funds (the leverage) on a short-term basis at the lowest cost available, meaning currencies with the lowest interest rates are used as funding currencies. In a risk-on environment, they then sell those currencies and use the proceeds to buy risk assets with greater price appreciation potential. In a risk-off environment, they’re compelled to sell their risk assets and buy back those funding currencies that they previously sold.
So what determines whether risk is on or off? In a word, volatility. Volatility refers to the size and speed of price movements over a short time frame, meaning hours or days. But volatility is the symptom and not the cause of those price changes. News and events are what dictate market reactions. In the simplest sense, when news and economic data are positive and everyone’s feeling good about the outlook, risk is on and risk assets tend to appreciate (see the following section for what constitutes risk assets). When the news or data turns negative or outright catastrophic in the case of the GFC, investors turn more cautious and may exit risk trades, potentially triggering widespread selling that may force prices lower and force other investors to bail out as well, amplifying the sell-off.
We have little doubt that much of the increase in the risk-on/risk-off trading dynamic in recent years is the result of algorithmic, or model-based, trading, which has taken on increased prominence in all markets. If the computer is told that an X percent change in one asset or indicator means it should exit an existing position, it will literally not “think” twice about selling out.
To follow the evolution of risk sentiment, it helps to have a good handle on the current state of market affairs and expectations (see Chapter 10 for how to get up to speed on these). For more empirical indications of risk sentiment, pay attention to the following:
On the other side of the risk equation (risk-off) are the supposedly safe assets, such as U.S. Treasury bonds, the USD, CHF, and JPY. When bad news and events hit markets (think the Great Financial Crisis or Eurozone debt bailouts), investors typically flee risk assets, selling stocks and commodities and buying the safety of government bonds and safer currencies like CHF, JPY, and the USD. Price moves in a risk-off environment can be extremely volatile because it’s a one-two punch where traders exit (sell) risk-on positions and also buy safer, risk-off assets.
3.22.66.140