Understanding a Crisis
Before we delve into how currencies behave during an economic crisis, it's crucial to understand why they are influenced by such periods. There's no doubt that currencies are affected by crises, as evidenced by any long-term chart. But why? There are several answers to this question, some of which are technical. However, here we will focus on
two key points.
- Currency is an expression of a country's strength. In the collective imagination, as well as in reality, a strong country has a strong currency, while a weak country has a weak currency. Strength and weakness are, of course, viewed from an economic perspective.
- Currencies are the driving force of the economy. This definition may be somewhat simplistic but is by no means improper. It's obvious: the transmission of assets depends exclusively on the performance of various national currencies, and to some extent, vice versa. It's no coincidence that currencies are also subject to the law of supply and demand.
That being said, the first step in understanding how certain currencies will behave in the event of an economic crisis is to grasp the
type of economic crisis at hand.
Indeed, there are various types of crises. The most common ones are:
- Demand-side crises. The crisis is triggered by problems related to demand. This occurs when, for example, the banking system is in difficulty, credit transmission mechanisms are struggling, and businesses are unable to obtain the liquidity they need. Jobs are cut and purchasing power is reduced at all levels. Generally, deflation occurs: goods are available and being produced, but they cannot be easily purchased. The 2008 crisis is a prime example of this type of crisis.
- Supply-side crises. The crisis is triggered by problems related to production. Demand does not suffer shocks, but it becomes difficult to satisfy. This happens, for instance, when the extraction and processing of raw materials experience slowdowns (e.g., the oil crisis of the 1970s). Such a crisis produces inflation: goods become scarce, and their prices rise.
Central Banks' Moves
In this article, we analyze the relationship between crises and currencies by considering the most common type of crisis, the demand-side crisis. This is because we have a wide range of case studies in this regard, including the 2008 crisis.
The most important step in understanding the complex relationship between crises and currencies is to analyze the behavior of central banks. Central banks manage the monetary transmission mechanisms. Simply put, these institutions "regulate the money taps." They can loosen the grip and allow more money to flow into the system by lowering interest rates or even purchasing debt securities from their respective states (Quantitative Easing). They can also tighten the grip, perhaps after a period of easing, by raising rates or reducing/halting purchases.
As we mentioned at the beginning of the article, currencies are not immune to the law of supply and demand but follow it to some extent.
Similarly,
an expansionary monetary policy (lowering interest rates, Quantitative Easing) increases the money supply, thus devaluing the currency to some degree.
Conversely,
a restrictive monetary policy (raising interest rates, reducing purchases, or suspending them) contracts the money supply, causing the currency to appreciate.
Real Economic Performance
Obviously, it is necessary to analyze real economies. As we have already mentioned, currencies are an expression of the economic strength of their respective countries. The vicissitudes of national economies, therefore, have a profound impact on the relationships between currencies, strengthening some and weakening others.
An economy that reacts better and sooner than others will see its currency increase in value. Conversely, an economy that reacts poorly and struggles to recover will see its currency depreciate.
What specific factors should be analyzed? The most important data are those
related to production, such as industrial production, GDP, and PMI indices. Labor market data are also crucial, with explicit reference to the unemployment rate, which should always be correlated with changes in employment.
The Acute Phase of the Crisis
A few words should be said about the behavior of currencies in the acute phases of crises. In this case, currencies often behave like any other asset. That is, they are extremely volatile and follow robust technical markets rather than the statements of this or that decision-maker. This also happens when the crisis reaches a turning point or when something unexpected occurs.
This was seen, for example, during the sovereign debt crisis, when it seemed that Italian (and other countries') debt had gone out of control. At that juncture, a single phrase from Draghi was enough to calm the markets and profoundly impact the euro (the famous "Whatever it takes").
It has also been observed in
this crisis, which is obviously still in its acute, very acute phase. Lagarde's words, finally announcing support for national debt through substantial Quantitative Easing, had a profound impact on the euro-dollar exchange rate (as well as on many other assets).
A Tip on How to Interpret the Signals
As you may have already guessed, the signals can be conflicting. What happens if, for example, an economy reacts poorly to the crisis and enters a deflationary spiral (a bullish signal), but the respective central bank opens the purse strings by issuing substantial Quantitative Easing and zeroing out rates (a bearish signal)? The question also applies to equal and opposite situations.
Generally, the factors listed so far operate in a game of forces and pushes. One force prevails over the other; one push prevails over the opposite push. Therefore, to anticipate currency movements in the event of a crisis, it is advisable not to limit oneself to merely reading the data but also to interpret and contextualize it.
