Keep an eye on geopolitics: it matters to the forex markets

OPPORTUNISTIC currency traders have always been quick to price in oil price spikes, non-standard monetary policies and signs of green shoots, sending currencies up and down depending on the level of risk aversion in the markets. Risk appetite, or the lack of it, has been a major driver of currency movements since the start of the financial crisis as traders have sought out safe havens like the dollar or the yen or risk trades like the commodity currencies.<br /><br />The North Korean missile test over the long weekend certainly brought an element of risk aversion back into the markets. The yen strengthened against 16 of its most-traded currencies, while the US dollar eased off its five-month lows. Excluding the yen, Asian currencies saw a broad sell-off: the South Korean won lost 1.4 per cent versus the yen and 1.1 per cent against the dollar. The won continued to fall yesterday after North Korea fired two more short-range missiles, sending further jitters through Seoul&rsquo;s stock market. The Singapore dollar and the Australian dollar were also slightly lower yesterday.<br /><br />It is important for traders to keep abreast of geopolitical developments and shift their assets accordingly &ndash; currency markets are the means by which international capital flows around the globe and therefore are usually the first to react to international events. <br /><br />But although there was some currency market movement to the missile tests and Iran&rsquo;s rejection of a Western proposal to freeze its nuclear developments in return for no new sanctions, the reaction has been somewhat less than you might imagine. Although the test brought reaction from big political players like the UN and President Obama, analysts noted that there was a knee-jerk reaction but added that because most Asian countries enjoy huge current-account surpluses, such an event won&rsquo;t change the overall international capital flow. <br /><br /><strong>KNEE-JERK REACTION</strong><br />After North Korea&rsquo;s first nuclear test on 9 October 2006 the won fell by 1.5 per cent, but had regained most of this loss within four days. Traders looking to make their move on the back of such geopolitical events should beware this retracement because the knee-jerk reaction is not always the consensus going forward.<br /><br />It is difficult for traders to measure just how much of an impact a geopolitical event will have. Richard Turner, foreign exchange sales dealer at IG Index, says: &ldquo;The impact depends on the gravity of the situation, but it is quite far down the list of issues; there are far more pressures on currencies at the moment.&rdquo;<br /><br />At the moment, markets are shrugging off the tests. North Korean belligerence is nothing new and it is thought the recent tests pose little risk to the region in general. South Koreans do not seem overly concerned about the developments in the north &ndash; although last month Kim Jong Il&rsquo;s regime tested a long-range Taepodong2 missile, South Korean consumer confidence reached its highest level in almost two years this month. Ratings agency Moody&rsquo;s said the north&rsquo;s actions would not affect the South&rsquo;s A2 credit rating, the sixth-highest investment grade. <br /><br /><strong>GEOGRAPHICAL LOCATION</strong><br />But if the situation gets worse in the coming days, then sentiment in the markets could change. George Tchetvertakov, head of market research at Alpari UK, says: &ldquo;If there were to be an escalation then the US dollar and the yen would be bought into.&rdquo; This would be at the expense of riskier commodity currencies; the Australian dollar and New Zealand dollar would be most affected purely because of their geographical location. <br /><br />The location of a geopolitical event is important in assessing its potential impact on currency pairs and the region. Any such events in the Middle East &ndash; such as developments in Iran&rsquo;s nuclear programme or military action in Iraq &ndash; can be dollar negative because of the potential impact on the supply of oil, which is priced in US dollars.<br /><br />Geopolitical issues focusing on Russia will have a proportionately larger effect on East European currencies such as the Polish zloty or the Ukrainian hryvnia; for example, Russia&rsquo;s war with Georgia last summer boosted the safe haven dollar at the expense of the euro. Stephen Lewis, economist at Monument Securities, estimated at the time that the euro would be first in the firing line if tensions escalated.<br /><br />Measuring the impact of geopolitical events on currency markets is impossible. Currency movements are affected by a huge range of factors, but forex traders should be aware of global hotspots and how changes in situations can affect their positions, and be ready to shift to safe havens if the worst should happen.