The Forex market – also known as foreign
exchange – is the largest and most liquid market in the world, with trillions
of US dollars being traded on a daily basis. Underpinned by currency interest
rate fluctuations, it is also arguably more volatile than the stock market,
given the multitude of economic and socio-political factors directly impacting
it.
Among these, monetary and fiscal policies are
the primary factors moving the Forex and equity markets, playing a pivotal role
in defining currency strength.
Understanding
the difference between monetary and fiscal policies
Monetary policy relates to central bank activities that dictate the
amount of money being printed and credit in an economy. Contrastingly, fiscal
policy refers to a set of government-established rules on taxation and public
spending to regulate economic activities.
Used concurrently to regulate economic
activity, they employ different tools to either accelerate or abate growth to
prevent the economy from slowing down or overheating, as the case may be.
Interest
rates, inflation & money supply
To safeguard economic stability, central banks
set inflation targets. They adjust the money supply through buying and selling
securities in the open market. These actions impact short-term interest rates,
which in turn, affect longer-term rates and the broader economy.2
When central banks reduce interest rates, it
is referred to as a monetary policy easing or a “dovish” stance. This
encourages consumer spending, investment, and business activity by making
borrowing cheaper.
For example, in June 2024, the European
Central Bank (ECB) decided to trim interest rates by 25 basis points for the
first time since 2019, causing the EUR to slightly depreciate against the USD
and other major currencies.
June 6-dated advanced prints from IronFX,
a leader in online Forex and CFD trading, traced the negative price action in
the EURUSD pair as traders had already priced in the ECB decision, hours ahead
of the official release.
EUR/USD H4
Chart
Support:
1.0864 (S1), 1.0795 (S2), 1.0727 (S3)
Resistance:
1.0910 (R1), 1.0980 (R2), 1.1047 (R3)
Conversely, a “hawkish”
stance involves raising interest rates, which is generally regarded as positive
for the currency.
In July 2022, the ECB adopted a hawkish stance
when it hiked interest rates by 50 basis points to steer inflation towards its
2% target, resulting in the Euro gaining momentum against the US
dollar.
How do
quantitative easing and tightening affect currency strength?
Quantitative easing (QE) and tightening (QT) are
broadly considered unconventional monetary policy tools used to manage
liquidity.
Through QE, central banks expand their balance
sheets by purchasing securities, including government and corporate bonds to
inject capital into the economy. Although it can stimulate economic growth, QE
can also cause the currency to depreciate due to the increased money supply.
Contrastingly, QT involves reducing a central
bank’s balance sheet by selling securities or allowing them to mature without
replacement. This leads to higher interest rates and a stronger currency.
Following the 2008 financial crisis, the Federal
Reserve employed QT to harmonise monetary policy, leading to a stronger USD as
liquidity shrinked and interest rates rose.
Bond
issuing & repurchase programmes
Central banks also use bond issuing and
repurchase programmes to control currency strength. These measures are often
utilised alongside QE and QT to either combat liquidity surplus (by fuelling
demand for domestic currency through bond issuing) or increase liquidity
(through bond buying and repurchase programmes).
During the COVID-19 pandemic, the Bank of England
(BoE) launched its bond repurchase programmes to kickstart the economy. As a
result, the GBP weakened as money supply increased.
Similarly, the ECB’s 2015 Asset Purchase
Programme (APP) funnelled billions of Euros into the economy,
stimulating consumer confidence while pressuring the single currency.
Understanding the implications of fiscal policy
As highlighted earlier, monetary and fiscal
policies work together to regulate business activities and secure growth.
Both government and central banks’ actions
significantly impact the economy, inflation, and currency strength,
reverberating across the financial markets.
Governments may adopt
either an expansionary or a contractionary fiscal policy, depending on the
domestic economic environment. An expansionary policy like the US government’s
stimulus packages during the COVID-19 pandemic, involves increased public spending
and borrowing.
While these measures can
provide immediate benefits, they can also raise concerns about inflation, as
seen in the USD’s mixed performance during that period.
Comparatively, a
contractionary fiscal policy involves reducing government spending and hiking
taxes to prevent the economy from overheating. This approach can strengthen the
currency and reduce inflationary pressures but may also slow economic growth.
Germany’s austerity
measures of 2010, aimed at reducing public debt in anticipation of the Eurozone
crisis, are a vivid example. While strengthening the Euro, they slowed economic
growth through higher taxes and lower government spending.
Broader
economic impact of monetary and fiscal policies
Monetary and fiscal policies have broad effects
on financial markets, influencing economic growth, market stability, and
investor sentiment. Understanding how financial markets react to policy shifts
is crucial for trading.
Impact
on the Forex market
Changes in interest rates, QE/QT, and public
spending directly influence currency movements and price action, as traders
adjust their positions to anticipated shifts. Likewise, fiscal policies have a
direct impact on currency strength and market dynamics.
Impact
on the bond market
Bonds are closely linked to monetary and fiscal
policies. Interest rate decisions affect bond yields which influence currency
strength. Rising bond yields attract foreign investment, leading to currency
appreciation. Similarly, fiscal policies affect bond yields and have a ripple
effect on currency price movements.
Impact
on the stock markets
Currency strength and stock market performance
are interrelated. A strong currency has a negative effect on export-focused
companies, leading to lower stock prices. In contrast, a weaker currency can
boost exports and improve corporate earnings, resulting in higher stock prices.
Therefore, traders must take into account monetary and fiscal policy decisions
when assessing potential stock market performance.
Impact
on the commodity markets
Lastly, commodities such as oil and gold are also
affected by monetary and fiscal policies. Generally, a weaker currency is
counterbalanced by higher commodity prices and vice-versa. However, this may
not always apply.
For example, during the
2008-2009 financial crisis, gold and the USD moved in tandem as investors
liquidated their positions to finance their USD-denominated debts (including
gold).6 Consequently, traders
must be cautious when analysing the relationship between commodity prices and
currency performance.
Joining
the dots
To sum up, understanding the complex relationship
between monetary and fiscal policies and their impact on the financial markets
is essential for developing a lucrative trading strategy. These policies not
only influence currency valuation but also have a broader impact on the
economy.
With this in mind, traders must stay informed
about financial market trends and economic events to inform their decision
making and navigate the complexities of the global forex market confidently.
IronFX offers a
wealth of tools and insights required to understand financial market dynamics
to empower traders on their journey. Visit the IronFX website for a clear overview of their offering.