CURRENCY TRADE
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Jittery forex markets are the new measures of political risk

The Turkish lira, Mexican peso and British pound will all be influenced this year by the countries’ politics rather than anything else

PUBLISHED : Thursday, 12 January, 2017, 12:02pm
UPDATED : Thursday, 12 January, 2017, 11:36pm

For the most accurate gauge of investor perceptions of political risk in advanced and developing economies, look no further than the world’s jittery foreign exchange markets.

Earlier this week, several currencies, which have become focal points of market anxiety about political and geo-political risks, suffered sharp declines.

On Wednesday, the Turkish lira sank to a fresh record low against the dollar, bringing its decline versus the greenback since the beginning of this year to staggering 12 per cent, making it the world’s worst-performing currency.

On the same day, the Mexican peso fell to a new all-time low against the dollar in the face of aggressive interventions on the part of the country’s central bank to help stem its decline.

On Monday, meanwhile, the pound resumed its fall after a weekend interview by UK Prime Minister Theresa May indicating that Britain would not try to keep “bits of membership” of the European Union, widely interpreted by traders as a sign that the country is going to leave the European single market.

In all three cases, political developments – or, more precisely, market interpretations of them – were the key factor driving sentiment.

Currencies have become the most reliable measure of investors’ sensitivity to political risk.

In a note earlier this week, HSBC’s currency research team noted that “a political view can give us a currency forecast. But just as importantly, the currency can also tell us where we are on the political scale.”

Gone are the days when government bond markets reflected investor concerns about political risk.

The ultra-loose monetary policies of the world’s main central banks have distorted bond prices significantly over the past several years and are keeping borrowing costs at extremely low levels. According to data compiled by the Financial Times, the stock of negative-yielding sovereign debt in Europe and Japan, although having fallen significantly in November as bond markets sold off, still amounted to $10.8 trillion early last month.

The so-called “bond vigilantes” in the 1980s and 1990s (and, more recently, during the acute phase of the eurozone crisis) have been replaced by a new form of vigilantism in global foreign exchange markets.

Currencies have become the vehicle through which investors can best express their views about political risk in both developed and developing economies.

The Mexican peso, dubbed the “Trumpometer” during the US presidential election campaign because of fears about president-elect Trump’s anti-trade rhetoric and his pledge to build a wall along the US-Mexican border, is the most sensitive currency to political developments.

The peso has plunged a staggering 19 per cent against the dollar since Trump’s victory, having already plummeted 24 per cent between January 2015 and the US election last November

The peso has plunged a staggering 19 per cent against the dollar since Trump’s victory, having already plummeted 24 per cent between January 2015 and the US election last November.

On Wednesday, Mexico’s currency was under further strain following an emotionally charged press conference by Trump in which he again threatened US manufacturers with “a major border tax” if they moved some of their production to Mexico.

The Trump-led run on the peso threatens to undermine the credibility of Mexico’s central bank whose interest rate hikes (in the face of a weakening economy) and sale of dollars have patently failed to help prop up the currency.

Another politically driven currency crisis is rapidly unfolding in Turkey.

On Wednesday, its lira fell 4 per cent against the dollar, its sharpest daily decline since the aftermath of the country’s failed military coup last July.

The lira has had the rug pulled out from under it because of a rapidly escalating terrorist threat and efforts by Turkey’s autocratic president, Recep Tayyip Erdogan, to take control of all levers of power.

Unlike Mexico, Turkey’s central bank is under intense political pressure not to tighten monetary policy, exacerbating the sell-off in Turkish assets and increasing the scope for a full-blown financial crisis.

Yet it is sterling, the world’s fourth most-traded currency, which should concern international investors the most.

Having staged a brief rally in October and November as fears about Britain’s impending exit from the EU (or “Brexit”) subsided, the pound appears to be entering a more dangerous phase as investors belatedly recognise that May’s government is much more concerned about controlling immigration than keeping Britain in the European single market.

It is now no longer about a “soft” or “hard” Brexit, but about a more or less orderly one or a destructive one in which the UK crashes out of the EU.

For currency traders, 2017 is all about politics.