The Influence of Politics

In this lesson you can learn:

• How politics could influence central bank policy
• Why stabilisations are something that investors tend to appreciate
• How the unexpected outcome of an election could cause significant moves on the markets

History shows a lot of the sharpest moves in financial markets were caused by political rather than economic events. For example, the Brexit vote and US election provided high volatility and multiple trading opportunities.

There’s a direct link between politics and economy, so it’s not a big surprise that politics can have a significant impact on financial markets. But how does this happen and why? Let’s find out.

Uncertainty Equals Volatility

An election - common for most countries - can have a large impact on the financial markets. Elections can be viewed by traders as an isolated case of potential political instability and uncertainty, which can lead to greater volatility on both stock exchange and forex market.

Let’s analyse how the market behaved ahead of the US elections in November 2016. The consensus was that Hillary Clinton would be the next President of the United States. The large majority of reputable polls gave Clinton a lead over Donald Trump, so the market was relatively calm as Trump was seen as the more ‘unpredictable’ candidate. However, his win was a big surprise, which led to some significant moves, as traders had to price in what his presidency may entail.

Because the large majority of conventionally trusted polls had Clinton in the lead, the markets did not seem prepared for a Trump victory. A similar situation occurred in the UK’s referendum on EU membership, where a largely unexpected ‘Leave’ vote caused a severe drop in the British pound and led to speculation that the European Union may disintegrate. These two incidents highlighted a seemingly global rejection of the established status quo, and called into question the accuracy of poll taking and measuring. Uncertainty, mistrust and disbelief can lead to more rapid movements in the market.

Change Is Not Always Welcome

A change in government often means a change in ideology, which could mean a different approach to monetary or fiscal policy, both of which, especially the latter, can be big drivers for financial markets. The dollar surged after Trump won the election, as the market expected a looser fiscal policy to force the Federal Reserve to raise interest rates.

Generally speaking, many believe that the more a government spends, the more the economy might grow, which could lead to a rise in inflation. In such a situation, the country’s central bank might decide to act by raising interest rates, which could support the currency. Additionally, many believe that political parties or individuals who are seen as more fiscally responsible or more concerned with promoting economic growth could boost both stocks market and the currency. So in the case where a government that is seen as an economy-friendly is in danger of losing its position of power, traders may react nervously and may sell the currency or stocks.

Searching for Stability

Stability is something that financial markets appreciate. As we’ve already covered, uncertainty is something that can have a negative impact on stocks market or a currency. However, it’s not always connected with a change of government when it comes to politics. Let’s recall what happened in 2012 when the Eurozone was on the verge of collapsing. Greece almost ran out of money and the politicians couldn’t find a clear solution. A similar scenario happened in 2015 when the country was within a whisker of leaving the Eurozone, resulting in some sharp moves on markets such as the DAX, CAC40 and many more.

It wasn’t until a political deal was reached in Brussels that the market was eventually stabilised. Although the measures put in place were far from perfect, the sense of stability caused quite a significant rally.

As you can see, politics could have a big impact on financial market. This is why it's good to follow the political scene closely.

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