The FX election effect: How currency markets could respond to geopolitical changes

Wed 5 Jun 2024
Posted by: Benjamin Roche
Features
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Currency markets are an important element of international trade and, as geopolitical risks rise, it’s important to be aware of where the next currency shift could come from.

To learn more, we spoke to James Tinsley, senior foreign exchange (FX) dealer at Currency Solutions, for the first in a series of conversations on what traders need to know on currency markets as well as how international politics and interest rate changes could affect them.

US election effect

Understanding how the US presidential election is likely to affect currencies means understanding more broadly how election results impact markets, Tinsley says.

“Whenever you come up to an election, what normally happens is one side is ‘good’ for a currency’s value and one side is ‘bad’.

“The good thing about this election is it’s happened before, four years ago. We can see from what happened then how it affected the market.”

This doesn’t necessarily mean that one candidate would be better for the US economy – just the value of the dollar.

Donald Trump, Tinsley explains, is seen as strong for the dollar, while incumbent president Joe Biden is seen as weak for the dollar. This is because, given the dollar is seen as a ‘safe haven’ currency, its value increases as global unrest or geopolitical instability increases.

With Trump “being a bit of a livewire” as well as “a bit more pro-Russia than pro-Ukraine”, it’s possible that he could withdraw support for the Ukrainian war effort.

“That,” Tinsley argues, “is going to put a lot of increased risk over Europe.” This means that, perhaps counterintuitively, Trump’s likely more turbulent presidency would bolster the US currency.

The UK in focus

With the next UK general election set for 4 July, there is renewed focus on the value of the pound and how a change of government could affect it. Tinsley says:

“The UK election is a little bit more boring [than the one in the US]. Labour look like they’re going to be a shoo-in, but the stronger the majority they get, the more volatility there’s likely to be in the market.”

Speaking before the announcement, he noted that a lack of detail from Labour on its economic policies had limited the extent to which currency markets could prepare for the party’s ideas should it enter government.

Broader trends

“We’ve seen a lot of unrest in the world over the last year,” Tinsley notes, particularly in the case of tensions between the US and China.

“As I said, any rise in geopolitical risk will be strong for the US dollar, but two other currencies that do well from geopolitical risk are the Japanese yen and Swiss franc. Everything else, especially the pound, [will weaken].

Geopolitical risks are hard to predict as they can “come out of nowhere”, he adds.

     If tensions continue to grow in the Middle East, the Ukraine war escalates further or there is conflict between China and Taiwan, that will also strengthen safe haven currencies.

On trade tensions between China and the EU, he explains that China’s rapid industrial development has left it less reliant on European imports despite Beijing’s historically strong exporting relationship with Berlin. This shifting relationship could mean a weakening euro.

Interest rates

On interest rates, Tinsley states that “we’re about to go through a global tightening cycle”.

“We had inflation go up after the pandemic, and central banks increased rates to control inflation. They’re starting to get a grip on that.

“Currencies basically get their strength from the interest rate. The pound, for example, will do well when the Bank of England raises interest rates, and will weaken when it cuts interest rates.”

With central banks announcing that they plan to cut rates, currencies will weaken as a result. The extent to which they do so will define how much currencies move in value relative to one another. As the US Federal Reserve continues to push back its planned cuts to the interest rate, for instance, the dollar continues to be strong.

The next few months hold change in currency markets, Tinsley concludes:

“As the markets try and work out what’s going to happen, and when the rate cuts are going to come into effect, we’re going to see quite a lot of volatility as they price these effects into the market.”