How to Trade the Impact of Politics on Global Financial Markets (Part 2)

January 31, 2024 12:51 PM +07:00

Pipscollector.com - Continued examples of political threats in Asia, Latin America and Europe

If you haven't read part 1, you can read Part 1 here.

How to Trade the Impact of Politics on Global Financial Markets Part 2 Pipscollector

ASIA: HINDU NATIONALISM IN INDIA

The re-election of Prime Minister Narendra Modi was broadly welcome by markets, though lingering concerns were raised about the effect of Hindu nationalism on regional stability. However, Modi has a reputation for being a business-friendly politician. His election lured investors into allocating a significant amount of capital to Indian assets.

However, investors’ optimistic outlook is periodically undermined by periodic clashes between India and its neighbors over territorial disputes. In the first breaths of 2019, India-Pakistan relations soured drastically amid a skirmish over the disputed Kashmir region. Since the 1947 partition, the hostility between the two nuclear powers has been an ever-present regional risk.

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

Tension between India and China, particularly over the disputed border known as the Line of Actual Control (LAC) in the Himalayan Mountains also rattled Asian financial markets. In June 2020, news of a skirmish between Chinese and Indian troops resulting in over 20 deaths raised concerns about what further escalation could mean 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

Source: TradingView

Nationalist campaigns and governments are embedded with political risk because the very nature of such a regime relies on displaying strength and frequently equates compromise with capitulation. In times of political volatility and economic fragility, the financial impact of a diplomatic breakdown is amplified by the fact that a resolution to a dispute will likely be prolonged due to the inherently stubborn nature of nationalist regimes.

US President Donald Trump and Modi employed a similar brand of strong rhetoric both on the campaign trail and within their respective administrations. In a rather ironic way, their ideological similarity may in fact be a force that causes a rift in diplomatic relations. Tensions between the two have escalated in 2019, with markets worrying that Washington may start another trade war in Asia, opening a second front in India having already engaged China.

HOW FX REACTS AS GOVERNMENTS, CENTRAL BANKS RESPOND TO GEOPOLITICAL & ECONOMIC STRESS

For economies with a high degree of capital mobility, there are essentially four different sets of policy-mix alternatives that can provoke a reaction in FX markets following an economic or geopolitical shock:

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. Below we will examine how various fiscal and monetary policy remedies for geopolitical and economic shocks impact currency markets.

SCENARIO 1 - FISCAL POLICY LOOSE; MONETARY POLICY BECOMES TIGHTER

On May 2, 2019 – following the FOMC decision to hold rates in the 2.25-2.50 percent range – Fed Chair Jerome Powell said that relatively soft inflationary pressure noted at the time was “transitory”. The implication here was that while price growth was below what central bank officials were hoping for, it would soon accelerate. The US-China trade war played a role in slowing economic activity and muting inflation.

The implicit message was then a reduced probability of a rate cut in the near term, given that the fundamental outlook was judged to be solid and the overall trajectory of US economic activity seen to be on a healthy path. The neutral tone struck by the Fed was comparatively less dovish than what markets had anticipated. This might then explain why the priced-in probability of a Fed rate cut by the end of the year (as seen in overnight index swaps) fell from 67.2 percent to 50.9 percent after Powell’s comments.

Meanwhile, the Congressional Budget Office (CBO) forecasted an increase in the fiscal deficit over a three-year time horizon, overlapping the central bank’s would-be tightening cycle. What’s more, this came against the backdrop of speculation about a bipartisan fiscal stimulus plan. In late April, key policymakers announced plans for a US$2 trillion infrastructure building program.

The combination of expansionary fiscal policy and monetary tightening made the case for a bullish US Dollaroutlook. The fiscal package was expected to create jobs and boost inflation, thereby nudging the Fed to raise rates. As it happened, the Greenback added 6.2 percent against an average of its major currency counterparts over the subsequent four months.

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