Influence of economic cycles on Forex currency exchange rates
It is natural that a trader who’s just starting to study fundamental analysis may wonder why EUR/USD doesn’t sink to parity. If the principle “a strong economy means a strong currency” works, how can the quotes of the main currency pair remain stable amidst the current divergence in the US’ and eurozone’s economic growth? While the currency bloc’s GDP is demonstrating the worst dynamics over the past 4 years, the US economy, on the contrary, reaches one of the best results over the past 10 years in April-September. So, why not buy dollars and sleep calm under such conditions?
The thing is, the economy develops in cycles: that’s where the shoe pinches. Expansion and boom follow recession and crisis. Each of the stages is characterized by certain features and central banks’ behaviour patterns. We have examined the power of their influence on Forex processes earlier. Now we are going to find out how regulators behave at certain stages of an economic cycle.
US GDP dynamics
Source: Trading Economics.
It’s obvious that the economy requires stimulation during the periods of crisis and recession. As for the monetary policy, the following measures are usually taken: reduction in interest rates, in payments to legal reserve funds and in the assets buyout program. At the same time, QE belongs to non-traditional forms of monetary expansion and its influence on financial markets and GDP isn’t examined in full. That’s why not all banks are ready to apply the quantitative easing program. A reduction in interest rates is considered to be a better option. The problem is that they can be too low at the moment of crisis and a reduction may cause serious trouble for the bank system.
Aware of the cyclic character of GDP evolution, a central bank has to provide for “ammunition” to fight a future recession. It means, it has to raise the rate as high as possible so that it can be lowered later for economic stimulation (but not too high in order not to cause any harm). Thus, a regulator’s important task is to bring the factor to a neutral level not to overheat or damp down the economy. That’s what the Fed is currently doing.
US Fed rate and GDP dynamics
Source: Trading Economics.
From the point of view of fundamental analysis, the toughening of a monetary policy is a bullish factor for a currency. Then, why isn’t the US dollar growing? Judging by some factors, the USA is at the stage of boom which will be followed by a recession. Under such conditions, the Fed will be forced to lower rates. I’m first and foremost talking about a slowdown in employment increase, the unwillingness of unemployment to continue its pitch-down, and the accelerated growth of average wages and inflation. The situation may get worse due to the exhaustion of fiscal stimulus effect, harmful influence of trade wars and growing risks of the inversion of the yield curve.
Theoretically, the Fed and the White House may extend the boom of the US economy through discontinuing the normalization cycle and increasing fiscal benefits. But we all know that the higher you fly, the more a fall hurts. Fiscal stimulus will be exhausted sooner or later while the lack of “ammunition” will bring a recession and crisis to a larger scale. Well, Donald Trump can always say “after us the deluge”, but it’s history, not him, will judge Jerome Powell.
Thus, don’t think that the principle “a strong economy means a strong currency” doesn’t work. The thing is, investors think about the future and estimate the risk of recession for the US economy in case of which USD bulls will get into trouble.
USD index and GDP dynamics
Source: TradingEconomics.
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Price chart of EURUSD in real time mode
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