Hawkish vs. Dovish: Monetary Policy Effects on Forex Traders
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May 16, 2023 01:12 PM Eastern Daylight Time
Monetary policy is one of the most important parameters influencing foreign exchange (forex) rates because central banks globally control the total currency in circulation by manipulating monetary policy tools such as interest rates and open market operations.
Over the past year, central banks around the world have deployed monetary policies to stabilize their economies amid increasing macroeconomic headwinds, resulting in heightened volatility in the forex market.
What are Hawkish Monetary Policies?
Hawkish monetary policies aim to curb the total currency in circulation, thereby appreciating the value of the respective currency. These policies include raising the benchmark federal funds rate, raising reserve limits for commercial banks and financial institutions, and selling government securities in the open market. These monetary tools restrict the total currency supply in the market, resulting in lower inflation rates and stronger currency value.
While the primary goal of a contractionary (or hawkish) monetary policy is to combat rising inflation rates, it deters unsustainable speculative spending and asset bubbles. However, these measures are often detrimental to economic growth and can result in deflation and high unemployment.
What are Dovish Monetary Policies?
Dovish or expansionary monetary policy aims to increase the total currency in circulation to encourage spending and capital investments. The Federal Reserve uses a plethora of tools such as lower interest rates, quantitative easing and shrinking bank reserve requirements to execute a dovish strategy. Lower federal funds rate and discount rates along with reduced reserve maintenance requirements boost the lending capacity of banks, which in turn increases the credit usage of consumers in an economy. Quantitative easing policies such as buying government securities like Treasury bills in the open market increase the supply of the dollar.
Dovish monetary policies are designed to fuel economic growth and reduce unemployment. But if left unchecked, such policies can harm the economy as it creates inflationary pressures and devalues the benchmark currency.
Impact of Monetary Policy on Forex Trading
Monetary policy is by far the primary driver of forex rates globally, as central banks heavily influence the total supply of currencies in the international market. A hawkish, or restrictive monetary policy, reduces the total supply of currency in circulation, causing its value to appreciate in the forex market. Conversely, an expansionary, or dovish monetary policy, focuses on boosting the total money supply, creating an excess supply in the forex market. This leads to a devaluation of the currency, causing corresponding forex rates to plummet.
Keeping updated with monetary policy-related information periodically released by central banks worldwide is key to becoming a successful forex trader. Novice and seasoned traders alike should follow all government news releases in order to predict forex trends as well as make calculated decisions regarding future monetary policy decisions.
The Federal Open Market Committee (FOMC) usually meets eight times a year (dates are displayed on the Federal Reserve website), following which it releases FOMC minutes of the meeting. These data releases give insights into the central bank’s future monetary policy decisions.
Past Monetary Policy Decisions That Affected Forex Traders
The Federal Reserve undertook one of the most aggressive hawkish stances in history last year to counter the burgeoning inflation crisis. Central banks around the world raised interest rates periodically throughout last year and this year to tackle rising prices, with the U.S. Federal Reserve raising its benchmark federal funds rate eight times in 2022 and once this year. Following the ninth consecutive rate hike, the federal funds rate currently stands at the highest level since 2007. Thanks to the hawkish policies, the U.S. dollar appreciated by more than 12% last year to hit a 20-year high last September.
But the Fed assumed a polar opposite stance during the first wave of COVID in March 2020, slashing the benchmark interest rates to near zero and launching a sizable bond buyback program. The U.S. dollar delivered its worst performance in three years. The index plummeted by over 6% throughout 2020, marking the biggest decline in the reserve currency since 2017.
How Forex Traders Can Use This Knowledge to Make Informed Decisions
It is common knowledge that a hawkish monetary policy typically coincides with currency appreciation, resulting in profits for forex traders that assume a long position. A dovish stance, on the other hand, causes a currency to lose value in the open market. Traders predicting central banks will adopt a dovish stance can short the respective currencies as they expect their values to decline in the near term.
Other Factors Influencing Forex Rates
Only knowing the difference between hawkish and dovish policies and leveraging that information for forex trading is not sufficient and can lead to immense losses. Even though the Fed raised interest rates once this year and signaled one or two more hikes by year-end, the U.S. Dollar Index erased all 2022 gains in less than four months in 2023. This is because traders are now worried about the ramifications of a potential recession and the worrisome banking crisis. Other macroeconomic data and geopolitical relations should also be considered in tandem with the monetary policy before making an informed decision.
This post contains sponsored advertising content. This content is for informational purposes only and is not intended to be investing advice.
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