How Do Politics and Central Banks Impact FX Markets? (Part 1)

HOW DO POLITICS AND CENTRAL BANKS IMPACT FX MARKETS

• How do monetary and fiscal policy measures impact currency markets?
• What is the Mundell-Fleming model and why does it matter for FX traders?
• How has policy from the Fed, ECB and BOC impacted USD, EUR and CAD?

MARKETS HAVE PASSED THE POLITICAL EVENT HORIZON

Pipscollector.com - For foreign exchange (“forex” or “FX”) traders, the constant background noise that politics represents is an inescapable blackhole. Traditional media drowns in punditry, while social media drowns in puns. It doesn’t matter what asset class you’re trading either.In recent years, even a single tweet from a politician has had the capacity to move not only currencies but also bonds,commodities, and equities.

In an increasingly fractious landscape, traders need a framework by which to interpret information and understand political developments as they happen. After all, politics can become policy after enough time and effort. To this end, FX traders need a way to interpret information and political developments in the context of how fiscal policy could change and how that might impact their portfolios.

Market participants need to pay attention to more than just fiscal policy, however. With central bank activity having gained considerable traction during the Great Recession and thereafter, monetary policy looks to be a powerful lasting influence on markets. Therefore, FX traders need a viable framework to analyze both fiscal and monetary policy in tandem.

ECONOMISTS HAVE A SOLUTION BEYOND THE IS-LM MODEL

Fortunately, one such framework exists: IS-LM-BP model, or what’s known colloquially as the Mundell-Fleming model. Through this framework, FX traders can analyze how directional changes in fiscal policy (e.g. changes in taxes or government spending) and monetary policy (e.g. changes in interest rates) interact to produce various market outcomes.

Before we delve into the framework, a bit of background history on the Mundell-Fleming model.

Mundell-Fleming is an extension of IS-LM, which itself is an equilibrium model used by economists to look at the relationship between interest rates (the real interest rate, “i” on the vertical axis of the chart below) and economic growth (real gross domestic product, “Y” on the horizontal axis).

IS-LM Curve – Interest Rates and Economic Growth (Chart 1)

Without going too far down the academic rabbit hole, there are two takeaways of the IS-LM model that carryover into understanding the Mundell-Fleming model.

First, that the downward sloping IS curve demonstrates that as the level of interest rates fall, the level of economic activity rises. This is intuitive: the more readily credit is available, the more economic activity will flourish.

Second, the upward sloping LM curve demonstrates that as economic activity rises, the level of interest rates rise too. This is also intuitive: stronger economic activity provokes inflation and higher bond yields in response.

THE IS-LM MODEL IS INAPPROPRIATE FOR MODERN ECONOMIES

Why is the IS-LM model insufficient for traders? The IS-LM model is a foundational concept that ultimately leads to the classic AS-AD supply-demand model. But the IS-LM model is applicable for self-sufficient and/or closed economies; such a framework is not appropriate for a globalized world where open economies co-dependent on one another are the norm. We need to move beyond for a more complete framework.

LM model. Developed independently from one another but eventually synthesized into one unified idea, the IS-LM-BP model incorporates capital flow into the equation.

There are two different capital flow constraints within the IS-LM-BP, or Mundell-Fleming model. Countries either seehigh or lowcapital mobility. Depending upon which it is, different policy mixes lead to divergent reactions in the markets.

As a rule of thumb, developed countries and their currencies (e.g. the US, UK, Eurozone, Japan, etc.) have high capital mobility. On the other hand, emerging markets and their currencies (e.g. Brazil, China, South Africa, Turkey, etc.) have low capital mobility.

For the sake of this discussion, we will look at the Mundell-Fleming model through the lens of high capital mobility economies only, and as a result, attempt to set forth a framework to understand how different fiscal and monetary policy mixes impact the major currencies like the US Dollar, Euro, British Pound and Japanese Yen.

In a follow-up report, we will show the implications of the Mundell-Fleming model through the lens of low capital mobility economies and the resulting impact of policy changes for emerging market currencies.

DIFFERENT POLICY MIXES LEAD TO DIVERGENT REACTIONS IN MARKETS

For high capital mobility economies, there are effectively four different sets of policy shifts that can provoke a reaction in FX markets. They are:

• Scenario 1: Fiscal policy is already expansionary + monetary policy becomes more restrictive (“tightening”) = Bullish for the local currency
• Scenario 2: Fiscal policy is already restrictive + monetary policy becomes more expansionary (“loosening”) = Bearish for the local currency
• Scenario 3: Monetary policy already expansionary (“loosening”) + fiscal policy becomes more restrictive = Bearish for the local currency
• Scenario 4: Monetary policy is already restrictive (“tightening”) + fiscal policy becomes more expansionary = Bullish for the local currency

It is important to note that for an economy like the United States and a currency like the US Dollar, whenever fiscal policy and monetary policy start trending in the same direction, there is often an ambiguous impact on the currency.

In other words, when viewed through the framework of the Mundell-Fleming model, when both fiscal and monetary policy are expansionary, or when both fiscal and monetary policy are restrictive, that currency is unlikely to see a significant directional move in the nearfuture.

Instead, armed with this insight, traders expecting a period of trendless oscillation in a given currency may be encouraged to set aside momentum- and trend-based strategies to adopt an approach optimized for range-bound conditions.

Mundell-Fleming Model Framework for High Capital Mobility Economies (Table 1)

Here are four examples in in the past decade from various high capital mobility economies from around the world that illustrate how using the Mundell-Fleming model as a framework for understanding politics and central banks would have given a trader an analytical edge.

Continue reading part 2 of the article in the Educational content section and update the latest forex knowledge from Pipscollector.

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