How Diverging Monetary Policy Affects FX Trends
Similarities in FX & Equities
The upcoming Transition
Where we Go From Here
Every market has its difficulties to trade. The foreign exchange is no different because there is volatility, around-the-clock news, and competition around the globe. However, the Forex market has one unique identifier that makes it easier to spots clean trends so that you can trade in the direction of the trend. The differentiator is monetary policies and more important, is diverging monetary policy which causes the greatest trends to trade for the retail speculative trader.
Today will discuss a similarity between Forex markets benefits of monetary policy divergence and the business cycle and equities. You also discuss what’s ahead for 2015 in terms of monetary policy divergence of major currencies and what trades are potentially developing so that you can see if opportunity is there for you.
Similarities in FX & Equities
Many traders and observers of markets are familiar with economic cycles or business cycles. At the very least, you’re likely familiar with peaks in troughs of cycles whereas a peak is known as times of expansion and growth in troughs are known as times of contraction or recessions like we saw in 2008 2009.
In the United States, there is the national Bureau of economic research that helps determine official dates of peaks and troughs in US business cycles, which lends to the credibility of their existence. Depending on where we are in the cycle, different sectors tend to do very well for stock investors.
In times of recession, defensive or secular markets often are attractive because their demand doesn’t waver based on the business cycle. However, as the economic son starts to shine and we reach a peak in the business cycle, more speculative ventures like technology firms tend to do better because people are more optimistic about the future.
The Forex market has a similar phenomenon with monetary policy cycles. In other words, some economies see peaks and troughs or cycles of interest rates and economic growth. During times of expansion, a cycle of interest rate hikes start to attract capital from around the world, which leads to a strengthening currency. Conversely, during a downturn in economic activity, which many economies have seen since 2007, a cycle of interest rate cuts are enacted by the central bank in order to encourage growth with loose money however in the immediate state, falling interest rates tends to send capital abroad. While the markets are fundamentally different, cycles affect both FX, equities, and other markets like commodities and bonds.
The Upcoming Transition
Over the last year, the biggest story in the foreign exchange market has been whether or not the Federal Reserve will begin to raise interest rates in 2015. The assumption of this move has attracted a lot of capital. Second to the Federal Reserve the United States, the Bank of England is also looking to raise interest rates. This is allow the British pounds to rise alongside with US Dollar and what appears to be the first rise of expansionary interest rate cycle, which as we learned earlier help strengthen the currency.
Conversely, commodity currencies (currencies whose home economy heavily demands on prosperity in a specific commodity like oil or gold), have seen a strong downturn in their interest rate cycle. This is most notably seen with the Canadian Dollar, Australian Dollar, and New Zealand Dollar however, other commodity dependent economies have also had to loosen monetary policy by cutting interest rates.
Where we go From Here
As simple as it may sound, when you recognize diverging cycles of monetary policy and opportunity awaits. That opportunity comes from recognizing buying opportunities of currencies whose interest rates are on the rise. These currencies can be bought against currencies whose interest rates are on the fall.
As of summer 2015, no major central bank has raised rates but the Federal Reserve and Bank of England appear to be the first.
Many savvy institutions have already bought the USD and GBP against commodity currencies however; many feel that trend could continue. While not a trade recommendation, you can easily see through many charts how diverging monetary policy provides trend traders some of the best opportunities in the Forex market.