central banks

How the forex market reacts as governments and central banks respond to geopolitical and economic stress

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As fiscal policy loosens; monetary policy tightens. 

Following the FOMC’s decision to keep rates in the 2.25-2.50 percent range on May 2, 2019, Fed Chair Jerome Powell stated that the relatively soft inflationary pressure noted at the time was “transitory.” The implication was that, while price growth was slower than expected by central bank officials, it would soon pick up. The trade war between the United States and China has slowed economic activity and kept inflation at bay. The Fed’s neutral tone was comparatively less dovish than markets had anticipated. This could explain why the priced-in probability of a Fed rate cut by the end of the year (as measured by overnight index swaps) dropped from 67.2 percent to 50.9 percent following Powell’s remarks.

The combination of expansionary fiscal policy and monetary tightening bolstered the case for a bullish outlook for the US Dollar. The fiscal package was expected to create jobs and increase inflation, causing the Fed to raise interest rates. Over the next four months, the US dollar gained 6.2 percent against an average of its major currency counterparts.

Meanwhile, the Congressional Budget Office (CBO) forecasted a fiscal deficit increase over a three-year time horizon, overlapping the central bank’s potential tightening cycle. Furthermore, this occurred against the backdrop of rumours of a bipartisan fiscal stimulus plan. Key policymakers announced plans for a $2 trillion infrastructure building programme in late April. 


Fiscal policy tightens; monetary policy loosens

The 2008 global financial crisis and the Great Recession that followed reverberated around the world, destabilising Mediterranean economies. This fueled fears of a regional sovereign debt crisis, as bond yields in Italy, Spain, and Greece reached alarming levels. Mandated austerity measures were imposed in some cases, helping to lay the groundwork for Eurosceptic populism, which has since haunted the region. 

Investors began to lose faith in these governments’ ability to service their debt and demanded a higher yield in exchange for what appeared to be an increasing risk of default. The Euro was in pain amid the chaos, as questions about its very survival arose in the event that the crisis forced a member state to leave the Eurozone for the first time.

On July 26, 2012, European Central Bank (ECB) President Mario Draghi delivered a historic speech in London that many would come to regard as a watershed moment that saved the single currency. He stated that the ECB is “willing to go to any length to protect the Euro.” “And believe me, it will be enough,” he added. This speech helped to calm European bond markets and bring yields back down. 

The ECB also established an OMT (Outright Monetary Transactions) bond-buying programme. Its goal was to alleviate stress in sovereign debt markets and provide relief to Eurozone governments in distress. While OMT was never used, the fact that it was available helped to calm nervous investors. At the same time, many of the Eurozone’s troubled countries implemented austerity measures to shore up government finances.

While the Euro initially rose as fears of its demise faded, the currency would depreciate significantly against the US Dollar over the next three years. By March 2015, it had lost more than 13% of its value. It’s easy to see why when you look at the monetary and fiscal structures. 

Austerity measures in many Eurozone countries limited governments’ ability to provide fiscal stimulus, which could have helped create jobs and increase inflation. Simultaneously, the central bank was easing policy in order to alleviate the crisis. As a result of this combination, the Euro fell against the majority of its major counterparts.

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