• Seb Paisley

How deglobalisation and political instability affect foreign exchange markets

Deglobalisation is a recent phenomenon following the period of “slowbalisation” since 2008 whereby global uncertainty and weakening political relations between advanced economies have led to countries pursuing more self-sufficient approaches. This is because outsourcing is a risk involved with globalisation and recent crises have caused the consequences to be felt in both the financial and goods markets. COVID-19 has accelerated the process that started in 2008 with the WTO forecasting the best-case scenario for trade as a return to the pre-2020 trendline, and the most likely outcome is a return to the previous trade volume growth rate but on a new pathway. Whilst shocks and instability cause headaches for central banks, they excite traders who can try and profit from the increased volatility seen by a 40% increase in FX trading volume in the last decade. Deglobalisation is a product of fraying international relations that makes the operation of multinational companies more difficult and so they are tending to expand the size of operations in one location rather than explore new locations. The importance of fraying international relations upon foreign exchange markets is not to be underestimated as many retail investors act on sentiment alone and so recent trade wars compounded with Brexit have led to very volatile currency markets.

Global instability is seen between the USA and China as frequent flare-ups in accusations of economic and political manipulation have led to strained relationships, and Brexit has left a sour feeling between the UK and the EU. The spike in volatility resulting from initial COVID-19 lockdowns across the globe has since subsided, but trading volumes are still high as economies will emerge from lockdown with differing success. Volatility provides both risk and opportunity and so investor behaviour will depend upon the appetite for riskier assets and so most currency activity may centre around the most common currencies (USD, GDP and EUR). There will likely be many more frictions between nations in the coming months, particularly in the travel industry due to its asymmetric importance in economies meaning that it will lead to economies having differing opinions on whether to open up. A new wave of volatility in FX markets will likely occur soon as the recovery paths of economies are controlled by central banks and the success of vaccination programmes. The UK may see an appreciation relative to the Euro due to the relative success of vaccinations allowing a much freer economy and so differences in growth paths.

Most major currencies are freely floating in exchange markets, except China who operate a dirty floating policy and is frequently accused of manipulation by the US. Freely floating currencies should provide little basis for speculation from investors as they should be at the perceived value, but if central bank action can be predicted ahead of time, it is possible to profit. The most important central bank policy to consider for forex markets is interest rate decisions in response to inflation fears. Recent inflation fears have led to speculation that central banks will raise interest rates to dampen the risk of inflation as pent-up demand is released alongside easing lockdown measures. Speculators may attempt to capitalise upon these rate changes and the subsequent impact on exchange rates. Furthermore, quarterly announcements of the major macroeconomic indicators serve as shocks to foreign exchange markets as significant deviations from expectations can result in sharp rises in trading volume. Lockdown and social media have played a part in increases in retail trading volume, and since major currencies are seen as a safe haven, the mixture of retail and professional investors creates a more unexpected environment and hence a more unstable market. Major currencies are more enticing to investors due to much higher liquidity or smaller currencies via options and derivatives to maintain reasonable liquidity without handling the currency itself are common FX products. The forecast for individual options and derivatives is difficult as most changes are results of central bank action, but the most important overall changes in the FX market are increased volatility and trade volume in unpredictable market conditions.

Deglobalisation and political instability have allowed for short-run speculation in foreign exchange markets and in particular, options with a low theta value that generate quick profits. Whilst the lockdowns are seemingly near an end, the deglobalisation has only just begun and so in the coming months there will be many opportunities but also risks in foreign exchange markets as even medical experts struggle to predict government decisions. Further to this, investigations into the global handling of the pandemic will undoubtedly cause a stir and worsening of relations to compound the effects of deglobalisation. Currencies have been seen as a safe haven for investors, but this has all changed recently and foreign exchange markets have fluctuated with no model to describe movements as it is often comments, not economic activity, that has sparked volatility. To conclude, the impact of weakening relationships and timid multinationals has created an FX environment that requires investors to carry much more risk than usual but presents much greater rewards if there is an appetite for profit.