Trade geopolitical risks, Japanese yen, US dollar, euro, Brazilian real, Indian rupee, 2016 election.

Here we will consider specific geopolitical situations and their impact on the markets with analysis of charts of various assets.

  • The global economy is becoming increasingly weak and vulnerable.
  • Markets are exposed to geopolitical dangers when their economic strength deteriorates.
  • Political challenges in Asia, Latin America, and Europe are only a few examples.

GEOPOLITICAL RISKS ANALYSIS

Markets become increasingly vulnerable to political risks as their capacity for causing market-wide volatility is magnified against the backdrop of weakening fundamentals. When liberal ideals — those that advocate free trade and integrated capital markets – are attacked on a global scale by nationalist and populist movements, the upshot is often uncertainty-driven volatility.

The limited ability of investors to price in political risk is what makes it so deadly and elusive. Traders may become agitated if the global political situation continues to evolve in an unpredictable manner.

Furthermore, political infections, like the coronavirus in 2020, have the potential to spread like a virus.

Markets, in general, are less concerned with political categorizations and more concerned with the economic policies inherent in the agenda of whoever has the sovereign reins. Investors are drawn to policies that promote economic growth because they want to put their money where it will earn the most money.

These include enacting fiscal stimulus plans, strengthening property rights, permitting free flow of products and capital, and eliminating growth-stifling regulations.

If these policies generate enough inflationary pressure, the central bank may respond by raising interest rates. This increases the underlying return on local assets, attracting investors and strengthening the currency.

A government whose underlying ideological predilections are opposed to the globalization gradient, on the other hand, may cause capital flight. Regimes that strive to tear the threads that have woven economic and political integration frequently generate a moat of uncertainty that investors avoid. Ultranationalism, protectionism, and populism have all been proved to have market-disrupting impacts in the past.

Traders will examine the scenario to see if it dramatically impacts their risk-reward setup if a state suffers an ideological realignment. If this is the case, they can reallocate capital and re-formulate trading methods to tip the risk-reward balance in their favor. However, as reformulated trading tactics are reflected in the market-wide allocation of money among multiple assets, volatility is exacerbated.

EUROPE: ITALY’S EUROSCEPTIC POPULISM

The election in Italy in 2018 roiled regional markets and finally spread throughout the whole financial sector. The rise of the anti-establishment Lega Nord and the ideologically ambiguous 5 Star Movement was built on a populist campaign with an implicit rejection of the existing quo. The uncertainty that accompanied the new administration was quickly priced in, resulting in a dramatic increase in volatility.

The risk premium for holding Italy’s assets increased, resulting in a more than 100 percent increase in 10-year bond yields. Investors demanded a bigger yield in exchange for tolerating what they believed to be a higher level of risk.

This was reflected in the huge widening of the spread on Italian sovereign debt credit default swaps, as fears of Italy becoming the centerpiece of another EU debt crisis grew.

EUR/USD and EUR/CHF: As fears of another Eurozone debt crisis grew, so did the price of Mediterranean sovereign bond yields.

As investors shifted their wealth to low-risk assets, the US Dollar, Japanese Yen, and Swiss Franc all rose against the Euro. A conflict between Rome and Brussels over the former’s financial objectives added to the Euro’s misery. Fiscal exceptionalism was a hallmark of the government’s anti-establishment nature, which led to increased uncertainty, which was reflected in a weaker Euro.

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LATIN AMERICA: NATIONALIST-POPULISM IN BRAZIL

Despite the fact that President Jair Bolsonaro is widely regarded as a flamboyant nationalist with populist overtones, markets welcomed his election with open arms.

His nomination of Paulo Guedes, a University of Chicago-trained economist who favors privatization and regulatory reform, bolstered investor confidence in Brazilian assets.

Ibovespa Index – Daily Chart

The benchmark Ibovespa equity index soared more than 58 percent from June 2018 to the Covid-19 global market crash in early 2020, compared to a little more than 17 percent for the S&P 500 during the same time period. The Brazilian stock market soared nearly 12% in a month during the election in October, as surveys predicted Bolsonaro would defeat his left-wing opponent Fernando Haddad.

The ups and downs in Brazilian markets have mirrored Bolsonaro’s market-disrupting pension reforms since his election to the presidency.

Investors believe that these fundamental changes will be powerful enough to take Brazil’s economy away from the brink of recession and onto a solid growth path free of unsustainable government spending.

ASIA: HINDU NATIONALISM IN INDIA

Markets reacted positively to Prime Minister Narendra Modi’s re-election, however fears about the impact of Hindu nationalism on regional stability remained. Modi, on the other hand, has a reputation as a business-friendly leader. His election enticed investors to put money into Indian assets in large amounts.

However, frequent confrontations between India and its neighbors over territorial disputes sometimes dampen investors’ optimism. In the first few months of 2019, India-Pakistan relations deteriorated dramatically due to a conflict over Kashmir. Hostility between the two nuclear powers has been an ever-present regional worry since 1947’s partition.

India Nifty 50 Index, S&P 500 Futures, AUD/JPY Fall After News Broke of India-Pakistan Skirmish

Tensions between India and China, especially over the disputed Line of Actual Control (LAC) in the Himalayan Mountains, shook Asian financial markets. The news of a battle between Chinese and Indian troops in June 2020, which resulted in over 20 casualties, sparked concerns about the consequences of further escalation for regional security and financial stability.

India Nifty 50 Index, S&P 500 Futures, US 10-Year Treasury Yield, USD/INR After News Broke of India-China Skirmish

Because the character of such a regime relies on exhibiting power and frequently equates compromise with submission, nationalist campaigns and regimes are fraught with political peril. The financial effect of a diplomatic breakdown is accentuated in times of political turbulence and economic fragility because a resolution to a disagreement is likely to take longer due to the intrinsically obstinate nature of nationalist regimes.

On the campaign trail and inside their own administrations, US President Donald Trump and Indian Prime Minister Narendra Modi used comparable aggressive rhetoric. In an unexpected twist, their ideological similarities could be a factor in causing a gap in their diplomatic relationship.

Tensions between the two countries have risen in 2019, with investors concerned that Washington may launch another trade war in Asia, this time in India, after having already engaged China.

HOW GOVERNMENTS, CENTRAL BANKS, AND FX REACT TO GEOPOLITICAL AND ECONOMIC STRESS

There are essentially four potential sets of policy-mix choices that can cause a reaction in FX markets following an economic or geopolitical shock for economies with a significant degree of capital mobility:

  • 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
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It’s worth noting that for an economy like the United States and a currency like the US Dollar, when fiscal and monetary policy begin to move in the same direction, the currency’s impact is often equivocal. We’ll look at how various fiscal and monetary policy responses to geopolitical and economic shocks affect currency markets in the sections below.

SCENARIO 1: LOOSE FISCAL POLICY; TIGHTER MONETARY POLICY.

Fed Chair Jerome Powell indicated on May 2, 2019, after the FOMC decided to keep rates in the 2.25-2.50 percent range, that the relatively moderate inflationary pressure identified at the time was “transitory.”

The inference was that, while price increase was slower than expected by central bank officials, it would shortly pick up. The trade dispute between the United States and China has slowed economic growth and kept inflation low.

Given that the fundamental outlook was deemed to be robust and the general trajectory of US economic activity was seen to be on a healthy path, the implied message was that a rate drop in the near future was unlikely. The Fed’s neutral tone was notably less dovish than market expectations. This could explain why the odds of a Fed rate decrease by the end of the year (as measured by overnight index swaps) have dropped from 67.2 percent to 50.9 percent after Powell’s comments.

Meanwhile, the Congressional Budget Office (CBO) anticipated a three-year increase in the fiscal deficit, overlapping the central bank’s planned tightening cycle. Furthermore, this occurred against the backdrop of reports that a bipartisan fiscal stimulus proposal was in the works. Key politicians unveiled plans for a $2 trillion infrastructure construction program in late April.

Scenario 1: DXY, 10-Year Bond Yields Rise, S&P500 Futures Fall

The combination of expansionary fiscal policy and monetary tightening supported an optimistic prognosis for the US Dollar. The fiscal package was projected to promote employment and inflation, prompting the Fed to raise interest rates. Over the next four months, the Greenback gained 6.2 percent against an average of its major currency peers.

SCENARIO 2: CURRENT FISCAL POLICY IS TIGHT; CURRENT MONETARY POLICY IS LOOSER

The global financial crisis of 2008 and the subsequent Great Recession reverberated around the world, destabilizing Mediterranean economies. As bond yields in Italy, Spain, and Greece soared to frightening levels, this fuelled fears of a regional sovereign debt catastrophe. In some situations, mandatory austerity measures were imposed, which contributed to the rise of Eurosceptic populism in the region.

Investors began to lose faith in these governments’ ability to service their debt, and they sought a higher yield in exchange for taking on what appeared to be a growing risk of default.

In the midst of the pandemonium, worries arose regarding the Euro’s very existence, especially if the crisis forced an unusual exit of a member state from the Eurozone.

Scenario 2: Euro Sighs Relief – Sovereign Bond Yields Fall as Insolvency Fears are Quelled

On July 26, 2012, European Central Bank (ECB) President Mario Draghi delivered a speech in London that many would come to perceive as a critical moment that preserved the single currency, in what is considered to be one of the most famous events in financial history. He stated that the ECB is “willing to go to any length to protect the Euro.” And believe me, that will be enough,” he added. This speech helped to calm European bond markets and lower yields.

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Scenario 2: Euro, Sovereign Bond Yields Fall

Austerity measures in many Eurozone countries hindered governments’ ability to provide fiscal stimulus that may have aided in job creation and inflation. Simultaneously, the central bank was loosening policy in an attempt to ameliorate the problem. As a result, the Euro fell against most of its major rivals as a result of this combination.

SCENARIO 3 – LOOSE MONETARY POLICY; TIGHTER FISCAL POLICY

The Bank of Canada (BOC) lowered its benchmark interest rate from 1.50 percent to 0.25 percent in the early stages of the Great Recession to alleviate credit conditions, restore confidence, and boost economic growth. The yield on 10-year Canadian government bonds began to rise, which was counterintuitive. This rise occurred at the same time when Canada’s benchmark stock index, the TSX, reached a bottom.

Scenario 3: USD/CAD, TSX, Canadian 2-Year Bond Yields

Investors’ preference for riskier, higher-returning investments (like stocks) over comparatively safer alternatives was reflected in the following restoration of confidence and recovery in share prices (like bonds). Despite the central bank’s monetary easing, this reallocation of capital pushed rates higher. The BOC subsequently began raising its policy interest rate again, eventually reaching 1%, where it remained for the next five years.

Prime Minister Stephen Harper enacted austerity measures during this time to help the government’s finances recover from the global financial crisis. By July 2015, the central bank had reversed direction and reduced rates to 0.50 percent.

Scenario 3: USD/CAD, Canada 2-Year Bond Yields

Because monetary policy was eased while fiscal policy support was limited, both CAD and local bond yields weakened. Cutting government spending during this difficult time, as it turned out, lost Mr Harper his job. Following a victory in the 2015 general election, Justin Trudeau took over as Prime Minister.

SCENARIO 4 – FISCAL POLICY BECOMES LOOSER AS MONETARY POLICY BECOMES TIGHTER.

The political atmosphere and economic backdrop encouraged a bullish prognosis for the US Dollar after Donald Trump was declared the winner of the 2016 US presidential election. The markets appeared to assume that the opportunity for political volatility had been diminished now that the Republican Party controlled the White House and both houses of Congress.

As a result, the market-friendly fiscal policies suggested by Trump during the election look to be more likely to be enacted. Tax cuts, deregulation, and infrastructure development were among them.

Investors appeared to overlook threats to launch trade wars against top trading partners such as China and the Eurozone, at least for the time. On the monetary side, central bank officials raised rates at the tail end of 2016 and were looking to hike again by at least 75 basis points through 2017.

Scenario 4: US Dollar Index (DXY), S&P 500 Futures, 10-Year Bond Yields (Chart 7)

With scope for fiscal expansion and monetary tightening in sight, the US Dollar rallied alongside local bond yields and equities. This came as corporate earnings expectations strengthened alongside the outlook for broader economic performance. This stoked bets on firmer inflation and thereby on a hawkish response from the central bank.

WHY DO POLITICAL RISKS AFFECT TRADING?

Numerous studies have demonstrated that a large drop in living standards as a result of a conflict or a severe recession increases the likelihood of voters taking radical political viewpoints. As a result, people are more likely to abandon market-friendly policies like capital integration and trade liberalization in favor of policies that are detrimentally inward-looking and anti-globalization.

Because the modern globalized economy is so intertwined politically and economically, every systemic shock has a high chance of reverberating around the globe.

During periods of high political volatility and intercontinental ideological shifts, it’s critical to keep an eye on these developments since they can lead to opportunities for short, medium, and long-term trading methods.


Read also: Forex trading during the news release

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