Inflation and growth are directly linked as strong economic growth leads to higher inflation. To ensure that prices in an economy do not rapidly rise, banking officials make use of the hawkish or dovish policy to strike the right balance between the two. Both policies affect forex trading by enabling traders to shift to currencies that are favoured by the policies.
In our article, we will understand Hawkish vs Dovish from a forex perspective and how they affect the forex market in general.
What does hawkish mean?
Hawkish is a contractionary monetary policy in which central banks increase interest rates to lower the country’s money supply. A rise in interest rate directly increases the country’s currency value in the forex market as higher interest rates attract more foreign investment that increases demand for the country’s currency. The appreciation of the currency in the forex market leads to a rise in demand for the particular currency pair, in turn increasing the currency value even further.
What does dovish mean?
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Dovish is an expansionary monetary policy in which central banks decrease interest rates to increase the country’s money supply. A fall in interest rate directly decreases the country’s currency value in the forex market as lower interest rates signal pessimistic economic growth. As a result, foreign direct investments fall, and so does the demand for the country’s currency. The fall in demand due to currency depreciation leads to a further fall in the currency’s value.
Hawkish VS Dovish: The Key Differences
A hawkish policy is followed when inflation is high, and so is the economic growth with a strengthened currency value. To curb the rising prices, interest rates are increased so that the inflation rate comes back under the central bank’s target level. This also results in a further increase in the home country’s currency value.
A dovish policy is followed when inflation is low, and so is the economic growth with a weakened currency value. To fight the dropping prices, interest rates are decreased so that the inflation comes back to the level decided by the central bank. This also results in a further decrease in the home country’s currency value.
2. Impact on forex prices
The hawkish policy is favourable from a currency value’s perspective as it increases the exchange rate and strengthens the currency in the forex market.
The dovish policy is not favourable from a currency value’s perspective as it decreases the exchange rate and weakens the currency in the forex market. However, it is favourable from a shorting perspective as traders can short trades (borrow funds to buy a currency pair at an exchange rate and sell them immediately before buying them back at a lower rate and returning them to the lender, keeping the difference in the rates as a profit) after a dovish policy is implemented.
3. Trading behaviours
Hawks are the traders who view rising inflation as a severe threat to the economy, and hence they are supporters of tight monetary policies. Such traders mostly invest in currencies of countries with strong economic growth and high inflation, with an expectation of the country imposing a contractionary monetary policy that will lead to a decrease in inflation, strengthened economic growth and increased exchange rates.
Doves are the traders who do not view falling inflation as an alarm but believe that quantitative easing is going to be beneficial for the economy. Hence, they support expansionary monetary policies and invest in falling currencies by shorting the trades.
Traders open short positions in currencies of countries with slow economic growth and low inflation, with an expectation of the expansionary monetary policy leading to a rise in inflation, better economic growth and a further fall in the exchange rate.
Let us consider that you wish to trade USD/EUR, which is currently trading at an exchange rate of 2. A rise in the American economy’s growth with high inflation leads the monetary policy officials to increase interest rates from 6% to 10%. This increase in interest rates will drive foreign investments from Europe and other countries as opportunities in America strengthen.
The increased foreign investment leads to an increase in demand for the US dollar, raising the USD/EUR exchange rate from 2 to 3, implying that now 3 dollars instead of 2 are needed to purchase one Euro, making the US Dollar more expensive in the market. The rising demand for the Dollar will further increase USD’s value in the market, leading you to place long or buy orders with respect to the USD.
Let us consider the same example of USD/EUR trading at 2. Now, assuming the American economy is facing a recession with slower economic growth, the monetary policy officials have decided to lower the interest rates from 6% to 4%. This decrease in rates will drive foreign investments out of the US economy and not attract any more investments from Europe or other countries as investors now believe that opportunities in America are shrinking.
This decreased foreign investment leads to a decrease in demand for the US dollar, as less of the currency is needed by other countries now. As a result, we assume the USD/EUR exchange rate to drop from 2 to 1.5, implying that now only 1.5 US dollars instead of 2 are needed to purchase one Euro, making the Dollar cheaper in the market. The falling demand for the USD will further decrease its value in the market, leading you to place short or sell orders for the USD.
Trade forex with the changing interest rates today
Following either the hawkish or dovish policy leads to a rise or fall in interest rates, respectively, directly affecting the forex currency values. You can long trades when a country increases its interest rates with a hawkish approach and short trades when it decides to decrease them with a dovish policy.
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