How to Trade the Impact of Politics on Global Financial Markets

How to Trade Geopolitical Risks

• The global economy is showing increasing weakness and fragility
• Eroding economic fortitude exposes markets to geopolitical risks
• Examples of political threats in Asia, Latin America and Europe

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ANALYZING GEOPOLITICAL RISKS

Against the backdrop of eroding fundamentals, markets become increasingly sensitive to political risks as their capacity for inducing market-wide volatility is amplified. When liberal-oriented ideologies – that is, those favoring free trade and integrated capital markets – are being assaulted on a global scale by nationalist and populist movements, uncertainty-driven volatility is the frequent result.

What makes political risk so dangerous and elusive is the limited ability investors have for pricing it in. Traders may therefore find themselves hot under the collar as the global political landscape continues to develop unpredictably. Furthermore, much like the spread of the coronavirus in 2020, political pathogens can have a similar contagion effect.

Generally speaking, markets do not really care about political categorizations but are more concerned with the economic policies embedded in the agenda of whoever holds the reigns of the sovereign. Policies that stimulate economic growth typically act as a magnet for investors looking to park capital where it will garner the highest yield.

These include the implementation of fiscal stimulus plans, fortifying property rights, allowing for goods and capital to flow freely and dissolving growth-sapping regulations. If these policies create adequate inflationary pressure, the central bank may raise interest rates in response. That boosts the underlying return on local assets, reeling in investors and lifting the currency.

Conversely, a government whose underlying ideological predilections go against the gradient of globalization may cause capital flight. Regimes that seek to rip out the threads that have sown economic and political integration usually create a moat of uncertainty that investors do not want to traverse. Themes of ultra-nationalism, protectionism and populism have been frequently shown to have market-disrupting effects.

If a state undergoes an ideological realignment,traders will assess the situation to see if it radically alters their risk-reward set up. If so, they may then reallocate their capital and re-formulate their trading strategies to tilt the balance of risk to reward in their favor. Volatility is stoked in doing so however as reformulated trading strategies are reflected in the market-wide redistribution of capital across various assets.

EUROPE: EUROSCEPTIC POPULISM IN ITALY

In Italy, the 2018 election roiled regional markets and eventually rippled through virtually the entire financial system. The ascendancy of the anti-establishment right-wing Lega Nord and ideologically-ambivalent 5 Star Movement was founded on a campaign of populism with a built-in rejection of the status quo. The uncertainty accompanying this new regime was then promptly priced in and resulted in significantly volatility.

The risk premium for holding Italy’s assets rose and was reflected in an over-100 percent spike in Italian 10-year bond yields. That showed investors demanding a higher return for tolerating what they perceived to be a higher level of risk. This was also reflected in the dramatic widening of the spread on credit default swaps on Italian sovereign debt amid increased fears that Italy could be the epicenter of another EU debt crisis.

EUR/USD, EUR/CHF Plummeted as Mediterranean Sovereign Bond Yields Spiked Amid Fears of Another Eurozone Debt Crisis

Source: TradingView

The US Dollar, Japanese Yen and Swiss Franc all gained at the expense of the Euro as investors redirected their capital to anti-risk assets. The Euro’s suffering was prolonged by a dispute between Rome and Brussels over the former’s budgetary ambitions. The government’s fiscal exceptionalism was a feature of their anti-establishment nature that in turn introduced greater uncertainty and was then reflected in a weaker Euro.

LATIN AMERICA: Nationalist-Populism in Brazil

While President Jair Bolsonaro is generally characterized as a fire-brand nationalist with populist underpinnings, the market reaction to his ascendency was met with open arms by investors. His appointment of Paulo Guedes – a University of Chicago-trained economist with a penchant for privatization and regulatory restructuring – boosted sentiment and investors’ confidence in Brazilian assets.

Ibovespa Index – Daily Chart

Source: TradingView

From June 2018 to the Covid-19 global markets rout in early 2020, the benchmark Ibovespa equity index rose over 58 percent compared with a little over 17 percent in the S&P 500 over the same time period. During the election in October, the Brazilian index rose over 12 percent in just one month as polls revealed that Bolsonaro was going to triumph over his left-wing opponent Fernando Haddad.

Since Bolsonaro’s ascent to the presidency, the ups and downs in Brazilian markets have reflected the level of progress on his market-disrupting pension reforms. Investors speculated that these structural adjustments will be strong enough to pull Brazil’s economy away from the precipice of a recession and toward a strong growth trajectory, unburdened by unsustainable public spending.

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

Source: TradingView

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. Read the full report here.

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

Source: TradingView

Scenario 2 – FISCAL POLICY TIGHT; MONETARY POLICY BECOMES LOOSER

Theglobal financial crisis in 2008 and the Great Recession that followed rippled out worldwide and destabilized Mediterranean economies. This stoked worries about a region-wide sovereign debt crisis as bond yields in Italy, Spain and Greece climbed to alarming levels. Mandated austerity measures were imposed in some cases which helped create the basis for Eurosceptic populism that hence haunted the region.

Investors began to lose confidence in the ability of these governments to service their debt and demanded a higher yield for incurring what appeared to be a rising risk of default. The Euro was in pain amid the chaos as doubtsemerged about its very existence in the event that the crisis forced the unprecedented departure of a member state from the Eurozone.

In what is considered to be one of the most famous moments in financial history, European Central Bank (ECB) President Mario Draghi delivered a speech in London on July 26, 2012 which many would come to see as a pivotal moment that saved the single currency. He said that the ECB is “ready to do whatever it takes to preserve the Euro. And believe me,” he added,“it will be enough.” This speech calmed European bond markets and helped bring yields back down.

The ECB alsocreated a bond-buying program called OMT (for “Outright Monetary Transactions”). It was aimed at reducing stress in sovereign debt markets, offering relief to distressed Eurozone governments. While OMT was never used, its mere availability helped becalm jittery investors.At the same time, many of the troubled Euro area states adopted austerity measures to stabilize government finances.

While the Euro initially rose as worries about its collapse receded, the currency would depreciate substantially against the US Dollar over the course of the following three years. By March 2015, it had lost over 13 percent of its value. When examining the monetary and fiscal set up, it becomes quite clear why.

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

Source: TradingView

Austerity measures in many Eurozone countries limited their governments’ ability to provide fiscal stimulus that might have helped create jobs and boost inflation. At the same time, the central bank was easing policy as a way to alleviate the crisis. Consequently, this combination pressured the Euro lower against most of its major counterparts.

Scenario 2: Euro, Sovereign Bond Yields Fall

Source: TradingView

Scenario 3 – MONETARY POLICY LOOSE; FISCAL POLICY BECOMES TIGHTER

At the early stages of the Great Recession, the Bank of Canada (BOC) cut its benchmark interest rate from 1.50 to 0.25 percent as a way to ease credit conditions, restore confidence and revive economic growth. Counterintuitively, the yield on 10-year Canadian government bonds began to rise. This rally came right around the same time as Canada’s benchmark TSX stock index established a bottom.

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

Source: TradingView

The subsequent restoration of confidence and recovery in share prices was reflected ininvestors’ shifting preference for riskier, higher-returning investments (like stocks)in lieu of comparatively safer alternatives (like bonds). This reallocation of capital sent yields higher despite the central bank’s monetary easing. The BOC then began to raise its policy interest rate anew and brought it up to 1percent, where it remained for the subsequent five years.

During this time, Prime Minister Stephen Harper implemented austerity measures to stabilize the government’s finances amid the global financial crisis. The central bank then reversed course and cut rates back to 0.50 percent by July 2015.

Both CAD and local bond yields suffered as monetary policy was loosened while the capacity for fiscal policy support was constrained. As it happens, cutting back government spending at this difficult time ended up costing Mr Harper his job. Justin Trudeau replaced him as Prime Minister following a victory in the 2015 general election.

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

Source: TradingView

Scenario 4 – MONETARY POLICY TIGHT; FISCAL POLICY BECOMES LOOSER

After Donald Trump was proclaimed the victor in the 2016 USpresidential election, the political landscape and economic backdrop favored a bullish outlook for the US Dollar. With the the Oval Office and both houses of Congress thus controlled by the Republican Party, the markets appeared to conclude that scope for political volatility had been reduced.

This made the market-friendly fiscal measures proposed by candidate Trump during the electionappear more likely to be implemented. These included tax cuts, deregulation and infrastructure building. 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.

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.

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

Source: TradingView

WHY POLITICAL RISKS MATTER FOR TRADING

Countless studies have shown that a significant decline in living standards from war or a severe recession increase the propensity for voters to take up radical positions on the political spectrum. As such, people are more likely to deviate from market-friendly policies – such as capital integration and trade liberalization – and instead focus on measures that turn away from globalization and are deleteriously inward-facing.

The modern globalized economy is interconnected both politically and economically and therefore any systemic shock has a high probability of echoing out into the world. During times of significant political volatility amid inter-continental ideological changes, it is crucial to monitor these developments because within them are opportunities to set up short, medium and long-term trading strategies.

— Written by Dimitri Zabelin, Analyst for DailyFX.com