Geopolitical events have short-term implications on currency markets

Carina Carin argues that geopolitical risks impact the USD, but only in the short-run.

February 17th, 2014 by Carina Carin in fxcurrencytradingsblog: “Geopolitical Risks and Events”

Geopolitics is nothing more than a fancy word used to describe what’s going on in the world at large. As it’s applied to the currency markets, geopolitics tends to focus on political, military/security, or natural disruptions to the global economy or individual regions or nations. Because currency markets are the conduits for international capital flows, they’re usually the first to react to international events, as global investors shift assets in response to geopolitical developments.

Currency markets have no national or patriotic allegiances when it comes to favoring one currency over another. The forex market simply calculates the likely economic fallout from any international event such as a military conflict or change of political leadership in a major economy and its likely currency impact. As such, you have to interpret each international event dispassionately, with an eye on the short and long term economic impact to determine its significance for individual currency pairs.

The United States tends to wield more influence on the world’s stage because it’s the largest national economy and the primary military superpower. In addition, the U.S. dollar is the largest global reserve currency and the de facto currency in many developing economies. Finally, with increasing globalization of trade and markets, the U.S. dollar frequently functions as a global risk barometer. For these reasons, the U.S. dollar tends to experience the greatest reaction in times of global turmoil or uncertainty, and the market tends to think in USD-positive and USD-negative terms, viewing all other currencies in contrast to the U.S. dollar. When geopolitical affairs are looking problematic, the USD tends to suffer. If the risks or tensions come down, the dollar may go up.

Elections in individual countries, including by-elections and legislative referenda, also fall under the geopolitical risk umbrella, especially when the outcome may lead to a change in government or economic policies. By elections (ad hoc elections to till individual legislative seats made vacant by death or resignation, for example) are typically seen as interim votes of confidence on the governing party. Depending on how near the next general election is, and on other economic factors, by-elections may have a greater effect on political sentiment. Legislative referenda, such as Canada’s Bloc Québécois efforts to secede from Canada in the 1990s, or the defeat of the European Union (EU) constitution by Dutch and French voters in 2005, are recent examples in which national political issues undermined the countries’ currencies.

As important as geopolitical issues are to the market’s overall assessment of a currency’s value, they tend to have relatively short-run implications and must be interpreted in light of other prevailing economic fundamentals. If the JPY is weakening based on a weak economic outlook, for example, and there’s a scandal in the ruling party, it’s just another reason to sell JPY. If the JPY is strengthening based on a more positive economic trajectory, a scandal is likely to represent only a short-term setback to an otherwise positive JPY scenario.