Geopolitics is nothing more than
a fancy word used to describe what’s going on in the world at large. As it’s
applied to the currency markets, geopolitics tends to focus on political,
military/security, or natural disruptions to the global economy or individual
regions or nations. Because currency markets are the conduits for international
capital flows, they’re usually the first to react to international events, as
global investors shift assets in response to geopolitical developments.
Currency markets have no national
or patriotic allegiances when it comes to favoring one currency over another.
The forex market simply calculates the likely economic fallout from any
international event such as a military conflict or change of political leadership
in a major economy and its likely currency impact. As such, you have to interpret
each international event dispassionately, with an eye on the short and long term
economic impact to determine its significance for individual currency pairs.
The United States tends to wield
more influence on the world’s stage because it’s the largest national economy
and the primary military superpower. In addition, the U.S. dollar is the
largest global reserve currency and the de facto currency in many developing
economies. Finally, with increasing globalization of trade and markets, the
U.S. dollar frequently functions as a global risk barometer. For these reasons,
the U.S. dollar tends to experience the greatest reaction in times of global
turmoil or uncertainty, and the market tends to think in USD-positive and
USD-negative terms, viewing all other currencies in contrast to the U.S.
dollar. When geopolitical affairs are looking problematic, the USD tends to
suffer. If the risks or tensions come down, the dollar may go up.
Elections in individual
countries, including by-elections and legislative referenda, also fall under
the geopolitical risk umbrella, especially when the outcome may lead to a
change in government or economic policies. By elections (ad hoc elections to
till individual legislative seats made vacant by death or resignation, for
example) are typically seen as interim votes of confidence on the governing
party. Depending on how near the next general election is, and on other
economic factors, by-elections may have a greater effect on political sentiment.
Legislative referenda, such as Canada’s Bloc Québécois efforts to secede from
Canada in the 1990s, or the defeat of the European Union (EU) constitution by
Dutch and French voters in 2005, are recent examples in which national
political issues undermined the countries’ currencies.
As important as geopolitical
issues are to the market’s overall assessment of a currency’s value, they tend
to have relatively short-run implications and must be interpreted in light of
other prevailing economic fundamentals. If the JPY is weakening based on a weak
economic outlook, for example, and there’s a scandal in the ruling party, it’s
just another reason to sell JPY. If the JPY is strengthening based on a more
positive economic trajectory, a scandal is likely to represent only a
short-term setback to an otherwise positive JPY scenario.
