Quantitative Easing and the Forex Market

The policy of quantitative easing (QE) and quantitative easing (QE) tapering has an effect on many markets worldwide. One of these markets is the Forex markets. In 2012, the mere news of a possible quantitative easing (QE) tapering by the Fed sent the world currency markets into a tailspin as many other currencies belonging to the developing countries (with huge fiscal deficits) faced historic lows against the dollar.

The cause and effect relationship between the quantitative easing (QE) tapering policy and the Forex market is unclear. However, the fact that such a relationship exists is certain. In this article, we will explore this relationship in more detail.

A Fresh Look at the Forex Rate

There are a lot of explanations given as to what Forex rates really are and what do they represent. Some of these explanations include increasingly complex theories about the functioning of the Forex market. However, for our purpose we will take a fresh new and simple look at the Forex markets.

So what is it that sets the Forex rates between any two currencies? How does the market determine that $1 equals 65 Rupees. The answers may sound complex but they all really point out to the same thing. The market expects that in future there will be 65 rupees in circulation for every dollar that is in circulation. The key word here is future expectations, not the present condition. At the present, there may be more or less than 65 rupees for every dollar. However, the market factors in the current news and creates a price which represents a future valuation. The Forex rate is therefore nothing but an expected ratio between the two currencies at a future date.

QE and the Forex Rates

The above being said, the quantitative easing (QE) policy can and does therefore have a profound effect on the Forex rates. This is because when quantitative easing (QE) takes place the government of one country unilaterally decided to increase or decrease the number of its currency units. This increase or decrease affects the ratio of that currency to other currencies in the market. Usually when the government follows the policy of quantitative easing (QE) , it increases the money supply by creating new currency and pumping the same into the bond markets.

For instance, when the US implemented the policy of quantitative easing (QE), it created billions of dollars and used them to buy troubled real estate assets as well as government bonds. However, the total number of dollars in circulation went up by billions of units. Therefore, the price and the purchasing power of the dollar in the Forex market are bound to fall unless the policy of quantitative easing (QE) is also used by other economies.

For instance, if both US and Europe are using quantitative easing (QE) then the currency pair of US/EUR may not fluctuate highly in value because the fall in value of the dollar may be more or less offset by the fall in value of the Euro and the effects may nullify each other.

However, if US adopts the policy of quantitative easing (QE) and India does not, then in that case, the number of dollars in circulation will increase but the number of rupees will not. Therefore the US dollar will lose its purchasing power relative to the rupee and this will reflect in the Forex market via dropped prices.

QE Tapering and the Forex Rates

The policy of quantitative easing (QE) tapering has the exact opposite effect as compared to the policy of quantitative easing (QE). Quantitative easing (QE) tapering creates a situation where in the speed at which new money was being supplied into the economy is reduced.

Therefore if the US announces the policy of quantitative easing (QE) tapering today, the markets assume that US will reduce the rate at which new money is being created. Therefore, the number of dollars that will be available for circulation in the market at a later date will be less than expected. Now, here too, there can be multiple scenarios.

If the US and Europe were to simultaneously announce the policy of quantitative easing (QE) tapering with about the same degree of magnitude, the Forex prices between these two currencies may not fluctuate that much.

On the other hand, if one of these countries were to announce the policy of quantitative easing (QE) tapering whereas the policies of the other remain unchanged, then the quantitative easing (QE) tapering would have a severe impact on the Forex rates between the given currency pair.

Impact on the Markets

Financial markets do not operate in vacuum. This is truer of Forex markets which operate on a 24 by 7 basis worldwide. Therefore even if multiple central banks were to implement the quantitative easing (QE) tapering policy in conjunction with each other, they would still end up creating ripple effects in the markets. They may be able to minimize or negate the effects between their currency pairs. However, the Forex market as a whole may face severe consequences. Many analysts believe that the almost certain event of quantitative easing (QE) tapering in the near future will wreck havoc in the Forex markets apart from many other asset markets in the world.