The war in the Middle East has been a paradigm shift for Forex markets. Beyond the obvious concern about a supply shock from energy and geopolitical uncertainty that has taken over the headlines, there is a more fundamental issue affecting currency markets.
Naturally, this will likely affect traders’ strategies, as markets operate on a different set of incentives. So, if you are wondering why your usual strategy is facing challenges in the current environment, this might explain it. It could offer insight into how to tweak your trading to account for the shift in forex market behaviour that will likely persist for some time, even if the war ends soon.
The Principal Forex Market Drivers
Normally, or at least mostly before US and Israeli missiles started landing in Iran, foreign exchange markets are driven by interest rates. That’s because investors are looking for the best return on their money, so they buy assets that offer the highest real interest rates at the lowest risk. The perception of which those are varies constantly, which is why currency pairs are constantly moving.
The underlying element that determines interest rates is the central bank. Investors typically don’t get central bank rates, but buy bonds in the currency they are interested in. Those bonds fluctuate in value depending on where people think inflation and interest rates are going. The interest paid on the bond, minus the expected inflation rate over the period, gives the real return on investment (RROI). Among currency majors, there is relatively little difference in default risk, so RROI is the principal driver of currency moves.
From Central Banks to the Economy
RROI is why the most important data for forex is usually CPI and the central bank meeting. Even more important than the economy, since economic performance is just one of the factors the central bank takes into account when setting interest rates. Bonds are issued with fixed interest rates that don’t fluctuate with whether the government is making more or less money.
However, in unusual circumstances, the economy can override interest rates due to large flows in equity markets. If everyone thinks the economy will tank, for example, they will sell stock and buy bonds. But that bond buying isn’t necessarily in the same currency. A flight to safety from, say, Japanese stocks might lead investors to buy US Treasuries. The market move can be large enough to disrupt the normal ups and downs tied to central bank expectations. Since stocks generally move with the economy, the economic outlook becomes more important to forex than the central bank outlook.
Where Are Markets Going?
This phenomenon was behind the large move in the dollar last year, with EURUSD rising 17%, a significant feat for a major currency. Investors thought US stocks were too risky and saw growth in European stocks. So, they sold dollars to buy Euros, driving EUR/USD higher despite the ECB growing increasingly dovish.
Now, the war in the Middle East is expected to have uneven impacts on global economies. This means that investors will shift their money from currencies where they think the economy will underperform, despite the central bank raising rates. Even because the central bank is raising rates. These are much larger currency flows that take time to materialise. Meaning that, just like with the greenback last year, it might take longer for market exhaustion to set in, so the usual tops and bottoms are harder to detect.
