How Geopolitics Influence Forex Markets

The global forex market is intrinsically linked to geopolitical events. Wars, coups, state collapses, and other turmoils can significantly alter investor confidence, influence market dynamics, and seemingly overnight flip market expectations.

Political Stability As a Commodity

Political stability plays a pivotal role in determining currency strength. Countries like Venezuela and Argentina, marred by political instability, have seen their currencies depreciate rapidly. For instance, Argentina's peso has continually weakened due to inflation, policy inconsistencies, and investor apprehension about government stability. Similarly, Venezuela's bolívar collapsed under hyperinflation and political turmoil, causing dollarization – a situation when residents of the country start unofficially using the US dollar as a currency.

For this reason, investors favor currencies from politically stable regions, leading to higher demand for safe-haven currencies like the US dollar (USD), Swiss franc (CHF), and Japanese yen (JPY).

In turn, this currency demand allows these countries to have high government debt levels because investors do not hold physical cash. Instead, they buy government bonds denominated in these currencies, which’re highly liquid securities.

Global Relations Drive Forex

Geopolitical tensions and conflicts are among the most disruptive forces in forex markets. For example, the US-China trade war led to tariffs and trade restrictions impacting the USD and Chinese yuan (CNY). Donald Trump’s second term as president will likely repeat these issues.

Meanwhile, the Russia-Ukraine war demonstrated how regional conflicts could influence global forex markets. Following the invasion, the Russian ruble experienced a dramatic devaluation, plunging to historic lows against major currencies due to severe economic sanctions imposed by Western nations. These sanctions included freezing Russian central bank reserves and cutting the banks off the SWIFT financial system.

In response, Russia implemented aggressive measures to stabilize the situation. The central bank sharply increased interest rates to 20% to curb capital outflows and attract foreign investment. It also imposed strict capital controls, limiting foreign currency withdrawals and mandating that exporters convert a significant portion of their earnings into rubles. Additionally, the government demanded that "unfriendly countries" pay for energy imports in rubles, boosting demand for the currency.

The Commodity Export Connection To Forex

Commodity-exporting countries rely heavily on stable commodity prices to maintain strong currencies. The link between commodity prices and forex is evident in nations like Russia, Canada, and Australia. Besides geopolitical events, the commodity market for natural gas, oil, gold, or iron ore can cause significant fluctuations. For instance, the Iraq War in 2003 led to spikes in oil prices, boosting the currencies of oil-exporting nations while straining oil-importing countries.

How COVID-19 Pandemic Triggered Forex Volatility?

The COVID-19 pandemic added a unique dimension to forex markets. During the early months of the crisis, the USD spiked as global investors sought safety in the world’s reserve currency.

The Federal Reserve's emergency measures to cut interest rates to near-zero and implement massive quantitative easing initially weakened the dollar. Still, the USD quickly rebounded as the pandemic disrupted global trade and investment, highlighting the dollar's status as a safe-haven currency.

The demand for the USD during global crises shows its central role in forex markets, even when the U.S. economy is under strain. This is partly due to the amount of dollar-nominated debt in foreign countries.

Central Banks And CBDCs

Due to their size, major economies' monetary and fiscal policies shape global forex markets. Central banks, including the US Federal Reserve and the European Central Bank, adjust interest rates, implement quantitative easing, and engage in forward guidance to influence currency values.

Higher interest rates attract foreign investment as they get higher returns on government bonds, thus strengthening the local currency. Conversely, rate cuts aimed at stimulating growth often lead to depreciation, as capital looks for higher yields. Easier financing for local businesses means a higher money supply in that currency.

For example, during the COVID-19 pandemic, the Federal Reserve set interest rates to near zero, weakening the USD relative to safe-haven currencies like the JPY and CHF. Similarly, the European Union implemented expansive fiscal policies, including stimulus packages, which initially weakened the euro (EUR) before stabilizing it as investor confidence returned.

As geopolitical and economic landscapes evolve, central bank digital currencies (CBDCs) could transform forex markets. CBDCs, issued directly by central banks, aim to modernize payment systems and reduce reliance on traditional banking infrastructure.

CBDCs could simplify cross-border transactions, reduce transaction costs, and increase transparency in international trade. However, their widespread adoption could also lead to significant shifts in forex markets. For instance, a stronger digital yuan backed by China's growing economic influence could shift currency flows in Asia, diminishing the USD's role in the region. Similarly, a digital euro could strengthen the eurozone's position in global trade.

While CBDCs offer exciting possibilities, they also pose challenges, such as privacy concerns, regulatory issues, and the need for international coordination to avoid currency wars in the digital space.

Opportunities And Risks In Chaos

Geopolitical volatility presents both challenges and opportunities. Traders benefit from heightened activity and price movements as volatility allows traders to capture larger moves, boosting their profits. Still, from the technical perspective, some standard approaches might not work – as volatility-based strategies might require a broader stop-loss, automatically negating the market advantage.

Traders typically use fundamental analysis to interpret economic indicators, news events, and political developments. Still, geopolitical developments can happen quickly and unpredictably. In such cases, fundamental analysis helps with historical comparisons—although those should be taken with a grain of salt as every situation is different.