Politicians control the economy and their policies can change the future growth
trajectory of an economy. Political risk that fundamental forex traders need to be
aware of comes in a few forms:
1. Changing of governments.
2. When policies change that could affect economic growth.
3. When unexpected circumstances arise that the market had not anticipated.
The key thing to remember with political risk is that traders like certainty – they like
to know who is in charge of an economy and that they will take the right decisions to
boost economic growth. Thus:
A low level of political risk tends to be currency positive
A high level of political risk tends to be currency negative
Greece is a good example of political risk and how high levels of political
uncertainty can weigh on a currency. In early 2010 a new government was elected
and it uncovered a huge gap in the budget deficit – Greece had been borrowing more
than it could afford to pay back and the country was nearly bust. The previous
government had covered this up.
This sent the markets into shock and since Greece is part of the euro zone the price
of the euro was sent tumbling from 1.45 to below 1.20 by mid-2010 (see Figure
1.19). Not since the end of the Second World War had a Western country defaulted
on its debt, and now Greece needed to get financial assistance from its European
partners, the International Monetary Fund (IMF) and the ECB to prevent this from
happening.
The market’s view that the euro zone was stable and therefore a safe investment was
shaken to the core. If Greece was in trouble, could it spread elsewhere? Indeed it did
and Portugal and Ireland also requested bailouts.
Once a country is labelled as being politically risky it can be a difficult mantle to
shake off. In the period April to June 2012 Greece had to hold two elections before
the new government came to power. This heightened political risk yet again and also
weighed on the euro as the markets fretted that Greece would vote in politicians who
did not want to stick to the terms of its bailout loans, which could have seen Greece
thrown out of the currency bloc.
Greece eventually did elect a political party who would comply with bailout terms,
but this was a difficult period for the euro, as you can see in Figure 1.20. It sold off
sharply from 1.34 in March 2012 to 1.24 during the second Greek election in June
2012.
Political instability can cause excess volatility in the FX market. When this happens
investors put their money in the safest place possible – such as cash or cash
equivalents like Treasury bonds – and sell risky assets that could fall in value.
safe haven and the risky currency. Traders should acquaint themselves with risky
currencies and safe havens since during periods of market panic – such as financial
crash, a geopolitical event or a natural disaster – the market tends to divide the
currencies into these two groups.
When the market panics there is typically liquidity flow out of risky currencies and
into safe havens. Conversely when the markets are stable and growth is good, when
there are no financial or geopolitical crises on the horizon and there haven’t been
any natural disasters, then this can be an environment that allows risky currencies to
appreciate.
Both risky and safe currencies can move on domestic factors that have nothing to do
with the overall market environment, but when the going gets tough the herd
mentality can take over in FX, so domestic fundamentals go out of the window and
fear takes over.
financial markets. Safe haven currencies have certain characteristics:
1. Political stability
2. Financial stability
3. They are usually deep and liquid, which means that they are frequently
traded.
The most important safe havens are:
The US dollar
The Japanese yen
The Swiss franc
The US dollar is the ultimate safe haven for a couple of reasons:
1. The US is the world’s largest economy and is thus considered stable
2. The US government has never defaulted on its debt.
The dollar is also the most widely owned currency in the world, which makes the
dollar attractive to hold in a crisis. If you need money fast you want to own assets
that are easy to sell, like the US dollar.
What this means for FX markets
When panic and uncertainty hit the markets traders want to buy the dollar, which
causes it to rise. For example, when Lehman Brothers filed for bankruptcy in
September 2008 the dollar sky-rocketed (see Figure 1.21). But how can that be, when
Lehman Brothers was an American company? That is the funny thing about the
dollar; it can rise even when the problem is the US economy.
off in times of market panic. A currency can be classified as risky if it has one or
more of the following characteristics:
1. Political instability.
2. The central bank does not do a good job of keeping growth stable.
3. The economy is reliant on commodities.
It’s fairly easy to see why the first two points can lead to a currency being described
as risky. This covers a lot of emerging market currencies like the Indonesian rupiah
and the Indian rupee. South Africa may no longer be strictly an emerging market
currency, but the rand is also considered risky due to continuing political uncertainty
and also its economic reliance on commodities including platinum and gold.
That leads me to the impact of commodities on certain currencies. Australia and
Norway are both politically stable and their economies are fairly healthy. However,
the Aussie dollar and the Norwegian krone are considered to be at the risky end of
the FX spectrum. This is because their economies rely heavily on their commodity
sectors for growth.
Norway relies on its oil industry while Australia relies heavily on its minerals and
mining sector. Commodity prices tend to be volatile and they are closely linked to
the economic cycle – when the economy is booming commodity prices rise, when it
slows down commodity prices tend to fall. Thus, countries that have large oil,
mining, or other commodity sectors tend to suffer from extremes. This causes
traders to worry as it gets harder to predict future growth, which can cause the
currency to be volatile.
For example, during the financial crisis in 2008, the Aussie dollar sold off against
the US dollar sharply as commodity prices crashed (see Figure 1.22).
The same happened to the Norwegian krone, as you can see in Figure 1.23. Risky
currencies tend to sell off particularly sharply against safe havens like the dollar
during periods of market panic like the financial crisis in 2008.
The concept of safe haven and risky currencies can make life a little easier for the
FX trader as there is some certainty about what currencies will do when markets
panic:
Safe havens tend to be bought
Risky currencies tend to be sold
trajectory of an economy. Political risk that fundamental forex traders need to be
aware of comes in a few forms:
1. Changing of governments.
2. When policies change that could affect economic growth.
3. When unexpected circumstances arise that the market had not anticipated.
The key thing to remember with political risk is that traders like certainty – they like
to know who is in charge of an economy and that they will take the right decisions to
boost economic growth. Thus:
A low level of political risk tends to be currency positive
A high level of political risk tends to be currency negative
Greece is a good example of political risk and how high levels of political
uncertainty can weigh on a currency. In early 2010 a new government was elected
and it uncovered a huge gap in the budget deficit – Greece had been borrowing more
than it could afford to pay back and the country was nearly bust. The previous
government had covered this up.
This sent the markets into shock and since Greece is part of the euro zone the price
of the euro was sent tumbling from 1.45 to below 1.20 by mid-2010 (see Figure
1.19). Not since the end of the Second World War had a Western country defaulted
on its debt, and now Greece needed to get financial assistance from its European
partners, the International Monetary Fund (IMF) and the ECB to prevent this from
happening.
The market’s view that the euro zone was stable and therefore a safe investment was
shaken to the core. If Greece was in trouble, could it spread elsewhere? Indeed it did
and Portugal and Ireland also requested bailouts.
Once a country is labelled as being politically risky it can be a difficult mantle to
shake off. In the period April to June 2012 Greece had to hold two elections before
the new government came to power. This heightened political risk yet again and also
weighed on the euro as the markets fretted that Greece would vote in politicians who
did not want to stick to the terms of its bailout loans, which could have seen Greece
thrown out of the currency bloc.
Greece eventually did elect a political party who would comply with bailout terms,
but this was a difficult period for the euro, as you can see in Figure 1.20. It sold off
sharply from 1.34 in March 2012 to 1.24 during the second Greek election in June
2012.
investors put their money in the safest place possible – such as cash or cash
equivalents like Treasury bonds – and sell risky assets that could fall in value.
The concept of safe havens and risky assets
An important trick of the trade in the foreign exchange market is the concept of thesafe haven and the risky currency. Traders should acquaint themselves with risky
currencies and safe havens since during periods of market panic – such as financial
crash, a geopolitical event or a natural disaster – the market tends to divide the
currencies into these two groups.
When the market panics there is typically liquidity flow out of risky currencies and
into safe havens. Conversely when the markets are stable and growth is good, when
there are no financial or geopolitical crises on the horizon and there haven’t been
any natural disasters, then this can be an environment that allows risky currencies to
appreciate.
Both risky and safe currencies can move on domestic factors that have nothing to do
with the overall market environment, but when the going gets tough the herd
mentality can take over in FX, so domestic fundamentals go out of the window and
fear takes over.
The safe havens
Safe havens are the currencies that traders tend to buy in times of distress in thefinancial markets. Safe haven currencies have certain characteristics:
1. Political stability
2. Financial stability
3. They are usually deep and liquid, which means that they are frequently
traded.
The most important safe havens are:
The US dollar
The Japanese yen
The Swiss franc
The US dollar is the ultimate safe haven for a couple of reasons:
1. The US is the world’s largest economy and is thus considered stable
2. The US government has never defaulted on its debt.
The dollar is also the most widely owned currency in the world, which makes the
dollar attractive to hold in a crisis. If you need money fast you want to own assets
that are easy to sell, like the US dollar.
What this means for FX markets
When panic and uncertainty hit the markets traders want to buy the dollar, which
causes it to rise. For example, when Lehman Brothers filed for bankruptcy in
September 2008 the dollar sky-rocketed (see Figure 1.21). But how can that be, when
Lehman Brothers was an American company? That is the funny thing about the
dollar; it can rise even when the problem is the US economy.
Risky currencies
The opposite of a safe haven is a risky currency. This is a currency that tends to selloff in times of market panic. A currency can be classified as risky if it has one or
more of the following characteristics:
1. Political instability.
2. The central bank does not do a good job of keeping growth stable.
3. The economy is reliant on commodities.
It’s fairly easy to see why the first two points can lead to a currency being described
as risky. This covers a lot of emerging market currencies like the Indonesian rupiah
and the Indian rupee. South Africa may no longer be strictly an emerging market
currency, but the rand is also considered risky due to continuing political uncertainty
and also its economic reliance on commodities including platinum and gold.
That leads me to the impact of commodities on certain currencies. Australia and
Norway are both politically stable and their economies are fairly healthy. However,
the Aussie dollar and the Norwegian krone are considered to be at the risky end of
the FX spectrum. This is because their economies rely heavily on their commodity
sectors for growth.
Norway relies on its oil industry while Australia relies heavily on its minerals and
mining sector. Commodity prices tend to be volatile and they are closely linked to
the economic cycle – when the economy is booming commodity prices rise, when it
slows down commodity prices tend to fall. Thus, countries that have large oil,
mining, or other commodity sectors tend to suffer from extremes. This causes
traders to worry as it gets harder to predict future growth, which can cause the
currency to be volatile.
For example, during the financial crisis in 2008, the Aussie dollar sold off against
the US dollar sharply as commodity prices crashed (see Figure 1.22).
currencies tend to sell off particularly sharply against safe havens like the dollar
during periods of market panic like the financial crisis in 2008.
FX trader as there is some certainty about what currencies will do when markets
panic:
Safe havens tend to be bought
Risky currencies tend to be sold
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