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Monetary Policy is More than Just the FX Market's Dominant Theme

Monetary Policy is More than Just the FX Market's Dominant Theme

John Kicklighter, Chief Strategist

Talking Points:

  • Risk trends may be the most comprehensive wind in the financial system, but monetary policy is currently stronger
  • A wide gap between fundamental value and prevailing prices among many asset classes can trace back to central banks
  • When evaluating this theme as a market driver; it is important to watch relative standing, change and the risk ties

See the DailyFX Analysts' 4Q forecasts for the Dollar, Euro, Pound, Equities and Gold in the DailyFX Trading Guides page.

Contrasting - some would say competing - monetary policy regimes is arguably one of the most effective driving forces in the currency market. Most FX traders and analysts evaluate the bearings of the Federal Reserve (Fed), European Central Bank (ECB), Bank of Japan (BoJ) and others key policy groups first when establishing a fundamental position. Given the natural 'relative value' aspect of this market, it is easy to understand the sensitivity. Yet, recognition of this theme alone does not reflect a full understanding of its influence.

In trading the market manifestation of monetary policy, movement does not come from a simple disparity course - not even a dramatic contrast like that behind the USD/JPY. The motivation for exchange rate movement comes from the changes in policy from the authorities themselves. The Fed is a good example of this concept. Though it is unique amongst the major central banks for its hawkish bearings (as mild as they may be, it still stands in dramatic opposition to its peers), the Greenback has not steadily climbed on the back of this favorable standing. Since early 2015, the Dollar has carved out a broad, sideways range with many of its major pairings like EUR/USD doing the same. If the currency is going to continue to rise, it will need to further its advantage by hastening the timetable or its counterparts need to lose ground en masse.

Understanding the changes in the policy spectrum is important for the rise and fall in FX rates, but the more systemic influence this theme carries is the sentiment distortion collectively proliferated over the past eight years. The natural rate of return in the market has continued to deflate on the back of easy policy, yet the lower risk tolerance that typically accompanies that less attractive backdrop has been temporarily counteracted by the policy groups' presence. Yet, the seeming tranquility this has promoted in the market is not permanent. The Fed has already backed off the gas with its 2013 Taper and 2015 rate hike. The BoJ has arguably curbed its effort with its shift from a steady QE to one market-defined (targeting the JGB 10-year yield). It seems only a matter of time before the ECB makes a symbolic first stage turn when it announces Taper. At some point, confidence in monetary will falter; and the value gap to be closed is enormous. We take a refresher on why monetary policy is a crucial driver and what to watch in today's Strategy Video.

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