Monetary Policy in 2020 and Its Impact on the Forex Market

 

During 2019, central banks around the world had been lowering interest rates in order to counteract the beginning of global economic weakness. So far, the measures had been effective, given that risk sentiment had improved, and the financial markets had continued to go higher. However, interest rates around the world are already around record lows and the central banks’ ability to stimulate the economy through currency weakness is reduced.

The US Dollar – big winner again

Since the 2008 financial crisis, the US Federal Reserve had cut interest rates to zero and had conducted quantitative easing in order to bring down the long end of the yield curve. The same had happened with the rest of the world until 2015-2016 came and rates in the United States had started to rise, while other developed countries (mainly Western Europe and Japan) were unable to raise them at all.

This move had changed completely the global financial picture since higher interest rates in the US had created a large demand for the US dollar and for US-based assets. The flow into the dollar had been aggravated by another important factor, that could continue to weigh on the market in the near and mid-term horizon.

We all know that the US dollar is the global reserve currency and as a result, the entire planet had borrowed using it. The demand for the dollar increases even further since foreign countries need to finance the debt and they do so by exchanging their own currency with the US dollar.

What could happen next?

Although the flows into the US dollar had sustained economic expansion while the rest of the world was weakening. As the process continues, eventually the US will have to suffer. That means a strong dollar will no longer be an asset, but a liability. The US dollar could be the most favored in the forex market, even though the Federal Reserve could change the monetary policy to an even more accommodative stance.

With $23 trillion in government debt and an already massive annual budget deficit (4.6% in the 2019 fiscal year), the dollar weakness will be the one escape when the monetary stimulation will no longer have an effect.

For the short-term, however, flows into the US dollar could continue, as long as the economic picture for the entire world won’t show significant signs of improvements. For how much the US will tolerate the strength of the dollar is still an unknown question.

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