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.
