What is fiscal policy?
Fiscal policies simply refer to how government authorities manage the economy, especially the financial aspects; they include public spending, taxation, and budgets. This is crucial for traders because these events can seriously influence forex markets and even throw them into chaos. Fiscal policy forex strategy development usually involves traders analyzing important policies that affect the economy and ultimately the strength of a currency.
Government spending
Governments spend money to run their activities throughout the country for 12 months. Government spending includes spending on infrastructure, welfare, and defense to ensure growth, provide services to its citizens, and ensure the security of the nation and economy.
Taxation
Taxes are the main source of government revenue. Raising revenue through income, corporate, and consumption taxes are common practices from governments around the globe to fund public spending and influence economic behavior. Taxes are among the core income sources for governments, and changing tax rates seriously affects the currency.
Budget: deficits and issuance
Simply put, when spending exceeds tax revenue, governments run budget deficits. They issue debt (bonds) to finance the difference, which affects interest rates and future fiscal policies.
Unlike monetary policies, fiscal policies are decided by elected governments and approved by political processes. The main goal is to positively influence economic growth, employment, inflation, and long-term stability. In the Forex trading context, fiscal policies shape capital flow in or out of the economy, and investor confidence depends on these policies over a medium and long-term horizon.
Monetary policy vs fiscal policy affect on Forex markets
While sounding similar, fiscal policy and monetary policy are two different concepts. Understanding these differences is crucial for forex traders to ensure they correctly understand these concepts and which ones are more relevant for the current price analysis.
Monetary policy
Monetary policy controls interest rates, liquidity, and quantitative easing (QE) to control inflation, growth, and currency strength. These policies are set by the central banks and are not political decisions.
Fiscal policy
Fiscal policies, on the other hand, use spending, taxation, and deficits to stimulate or slow down the economy, impacting growth and currencies. They are set by governments solely on political procedures, unlike monetary policies.
Monetary vs fiscal policy affect on forex markets
Monetary policy moves currencies much faster via rate changes and liquidity, while fiscal policies influence longer-term momentum in currency trends through growth and debt dynamics. When both policies align, is when the strongest currency moves follow.
Fiscal stimulus impact FX analysis
The fiscal policy effect on forex markets is profound and works through several interconnected channels, like economic growth, inflation expectations, interest rate expectations, investor confidence, and more.
- Economic growth - Higher government spendings boost demand and GDP, ultimately attracting foreign investments and supporting domestic currency strength
- Inflation expectations - Large deficits can negatively affect inflation expectations, meaning investors will await higher inflation, weakening the currency if growth does not mitigate rising prices
- Interest rate expectations - Markets usually anticipate central bank responses to fiscal policies, which makes future rate changes priced into the Forex
- Investor confidence - Credible, disciplined fiscal policy supports long-term currency stability, while reckless government spending erodes trust and is damaging for the economy and currency
To properly analyze these policies, traders should know how governments' spendings are related to currency valuations.
Government spending and currency values
Government spending is a crucial economic factor that can significantly impact how the economy functions and grows. When a policy becomes expansionary, it typically includes infrastructure investments, social programs, and increased defense spending. When you are working on your fiscal policy forex strategy, all these aspects matter a lot, because they can dictate where interest rates will go and how currency will react to all of it in the medium and long-term window. Governments sometimes start developing new infrastructure, be it new roads, railways, and so on. This can only be done through increasing the spending, and as a result, traders can analyze relevant sectors and invest in stocks to capitalize on this new information. Social programs are also a major concern for any advanced government. If you see signs that the government is about to increase its spending, it becomes much easier to anticipate currency movements and capitalize on major forex trends.
Forex impact analysis
Forex markets are impacted in both the short and long term. They react differently in the short-term and do something else in the long run. The short-term forex impact of fiscal policy is often bullish, strengthening currency due to growth optimism. The long-term fiscal stimulus impact FX depends on debt sustainability and productivity gains. This dynamic is at the core of fiscal stimulus's impact on FX traders, and they always monitor major policies to ensure nothing slips.
Taxes and forex markets: How they interact
Tax cuts and tax increases can have a profound immediate effect on foreign currency rates and volatility. When the government announces tax cuts or actually does so, consumption and investment are both boosted. This is because businesses are incentivized to expand due to rising profits, and lower taxes can provide. If some businesses were struggling to make profits, with lower taxes, they could become profitable again. Tax cuts also strengthen the currency if the economic growth caused by them accelerates. However, this is not always the case, and traders should analyze the broader market context first before jumping into conclusion due to a single event.
Tax increases also impact forex markets nearly instantly. Tax increases slow down economic activities in the beginning and can weaken the currency in the short-term. However, if the debt improves in the long-term, then tax increases can even support the currency strength and have bullish effects.
Budget deficits, debt, and currencies
When the government spends more than it earns from taxes and other revenues, it runs a deficit and must borrow more money to continue operating. This has been the case with most advanced economies nowadays, where countries run trillions of dollars in deficit, starting from the United States.
Persistent budget deficits usually:
- Increase borrowing - Governments have to issue more debt to cover all their spending, which usually means more money printed and higher inflation
- Raise long-term risks - Investors demand higher returns as the government debt they are holding becomes riskier
- Pressure the currency downwards - More debt and risks reduce confidence in the currency, which creates bearish pressure on the fiat
Countries with rising debt levels and weaker economies usually see their currencies lose value rapidly, because investors try to invest in safer and stronger currencies and economies.
Fiscal stimulus impact FX: Real-world logic
Fiscal stimulus can sometimes support currencies. This only happens when it boosts real economic growth without harming the debt stability (no significant increase in debt). The fiscal stimulus supports currencies when factories and workers can produce more without causing inflation spikes. The debt should be at manageable levels, meaning markets must trust the governments enough that they can repay their obligations. Spending should raise productivity, not vice versa. Infrastructure and education spending should improve long-term growth.
Weak or poorly managed stimulus, like it often happens with 3rd world economies, has no effects or even negative effects. Wasted spending, corruption, and political instability add debt without growth, which weakens the currency instead of supporting it.
Developed vs emerging markets
As we have already mildly discussed, the impact of fiscal policy differs between developed and emerging markets. Developed markets can easily tolerate higher deficits as their economies are supported by either manufacturing or other industries, ensuring a stable and advanced environment. Forex impact, in this context, is gradual and not dramatic, and currency trends play out over years, offering stable and persistent trends to follow. Emerging markets are a whole different story, on the other hand. This is because emerging markets are much more sensitive to fiscal policies due to a weaker economy. Fiscal expansions can trigger panic sell mode and throw markets into bear frenzy, which is never a good thing for investors. Fragile economies should avoid dramatic increases in government spending to avoid such volatile and adverse market scenarios. The risks of capital flight are much higher as investors try to protect their capital and often just withdraw their money to avoid large losses.