political-risk-and-currency-moves — currency markets and fx strategy

How Politics Moves Currencies

Currency markets respond to political events through their impact on expected economic policy, capital flows, and risk premiums. A change in government can signal shifts in fiscal policy, central bank independence, trade relationships, or regulatory frameworks—all of which affect currency valuations.

Political risk creates uncertainty, and uncertainty increases the premium investors demand to hold a currency. This premium shows up in higher volatility, wider bid-ask spreads, and often persistent currency weakness until the uncertainty resolves.

Election Impacts on Currencies

Elections generate currency volatility through several channels:

Pre-election uncertainty: Markets typically price increased volatility 1-3 months before major elections. Option implied volatility often rises 20-50% above normal levels during this period.

Policy divergence: When candidates have significantly different economic platforms, currency moves accelerate as polls shift. Markets attempt to price probability-weighted outcomes.

Post-election adjustment: The actual result triggers immediate repricing. If the outcome differs from consensus expectations, moves can be particularly sharp.

Historical Election Impacts

Event	Currency	Move	Timeframe
2016 US Presidential Election	USD/JPY	+5%	Election night
2016 US Presidential Election	USD/MXN	+13%	Election night
2017 French Presidential Election	EUR/USD	+2%	First round results
2018 Mexican Presidential Election	USD/MXN	-5%	Post-election week
2022 Brazilian Presidential Election	USD/BRL	+4%	Election week

The 2016 US election illustrates how unexpected outcomes create large moves. Pre-election polls favored Clinton, and markets had positioned accordingly. Trump's victory triggered immediate dollar strength against most currencies, with the Mexican peso particularly affected given trade policy concerns.

Policy Uncertainty and Regime Change

Beyond elections, policy uncertainty can persist for extended periods and pressure currencies:

Coalition instability: Governments with fragile majorities face constant uncertainty about policy continuity. Italian politics has historically created euro volatility during coalition negotiations.

Institutional challenges: Threats to central bank independence or judicial institutions raise concerns about policy predictability. Markets treat such challenges as negative for currency stability.

Economic policy shifts: Sudden changes in tax policy, spending priorities, or regulatory frameworks can trigger capital flight if markets perceive them as damaging to growth or investor returns.

The UK's September 2022 mini-budget provides a recent example. The proposed unfunded tax cuts under Prime Minister Truss triggered a 5% GBP decline in a single day and 10% over two weeks, demonstrating how markets respond to perceived fiscal irresponsibility.

Sanctions and Capital Controls

Government-imposed restrictions on capital flows directly impact currency markets:

Sanctions: When major economies impose sanctions, the targeted country's currency typically falls sharply. The Russian ruble lost approximately 50% of its value in the weeks following Western sanctions in early 2022, before partially recovering due to capital controls and current account support.

Capital controls: Governments facing currency crises sometimes impose restrictions on capital outflows. While these can temporarily stabilize the currency, they typically signal deeper problems and reduce long-term investor confidence.

Types of capital controls:

Limits on foreign currency purchases
Required holding periods for foreign investments
Taxes on capital outflows
Restrictions on profit repatriation

Argentina's repeated implementation of capital controls illustrates the pattern. Each round of controls provided temporary stability but reinforced perceptions of instability, contributing to persistent peso weakness over time.

Case Study: Brexit and the British Pound

The 2016 Brexit referendum offers a comprehensive case study in political risk pricing:

Pre-referendum (2015-June 2016): GBP/USD traded between 1.40-1.50, with volatility increasing as the vote approached. One-month implied volatility rose from 8% to over 20%.

Referendum result (June 24, 2016): The unexpected Leave victory triggered a 10% GBP decline against the dollar overnight—one of the largest single-day moves in modern currency history. GBP/USD dropped from 1.50 to 1.33.

Post-referendum uncertainty (2016-2019): GBP remained volatile throughout the negotiation period, with moves of 2-5% around key parliamentary votes on Brexit terms.

Total impact: From pre-referendum highs to October 2016 lows, GBP lost approximately 20% against the dollar. Much of this decline proved persistent, with GBP never fully recovering its pre-Brexit levels.

Case Study: Turkish Lira Crisis (2018)

Turkey's 2018 currency crisis demonstrates how political and policy factors compound:

Background: Rising inflation, current account deficit, and political pressure to keep interest rates low despite inflation concerns.

Trigger events:

Diplomatic dispute with the US over detained American pastor
US sanctions and tariff announcements
Market concerns about central bank independence following election consolidating presidential power
Comments suggesting interest rates would remain low despite currency weakness

Currency impact: USD/TRY rose from 4.0 to 7.2 between April and August 2018—a lira depreciation of approximately 45%. At the peak of the crisis, the lira fell 20% in a single week.

Feedback loops: Currency weakness increased the local currency cost of dollar-denominated corporate debt, raising credit concerns and triggering further outflows.

The Turkish case illustrates how political factors (central bank independence concerns, diplomatic disputes) interact with economic vulnerabilities (external debt, current account deficits) to create severe currency stress.

Measuring Political Risk

Several approaches help quantify political risk exposure:

Option-implied volatility: Elevated implied vol relative to realized vol suggests markets are pricing future uncertainty. Election periods typically show this pattern.

CDS spreads: Sovereign credit default swap spreads reflect perceived default risk, which correlates with currency risk in stress scenarios.

Political risk indices: Various providers publish country-level political risk scores incorporating factors like:

Government stability
Institutional quality
Policy predictability
Social stability
Regional security

Risk reversal skew: The price difference between out-of-the-money puts and calls indicates directional bias in hedging demand. Strong negative skew suggests concern about currency depreciation.

Checklist: Assessing Political Currency Risk

When evaluating political risk exposure in a currency position, consider:

Positioning Around Political Events

Currency traders approach political events with varying strategies:

Reducing exposure: Many institutional investors reduce position sizes ahead of binary political events, accepting missed opportunities to avoid event risk.

Options strategies: Buying straddles or strangles allows participation in large moves regardless of direction. However, elevated implied volatility makes this expensive around well-telegraphed events.

Hedging existing exposure: Corporate treasury teams often increase hedge ratios ahead of political uncertainty affecting their operating currencies.

Opportunistic positioning: Some traders take directional views on political outcomes, though this approaches speculation given the difficulty of forecasting political events.

The key principle is that political events can generate moves of 5-20% in a short period—sufficient to overwhelm normal trading profits or create substantial losses. Position sizing and hedging should account for this tail risk.

Political Risk and Currency Moves