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Deflation in Forex Trading

One of the biggest problems in recent years came from a source no major economist expected: deflation. While every trader that respects his/her work knows what inflation is and how it influences the currency market, few at that time had heard of deflation.

Lately, this changed, because deflation gripped the world economy by the time oil fell out of bed, with the move from $100 to $30 sparking a deflationary spiral. As such, major economies around the world struggled to fight it and central banks searched for the antidote to it.

Inflation and Its Role

Any discussion about deflation should start from its 'sister' inflation. This is on every trader's lips. And, for a good reason.

Inflation appears on every central bank's mandate. From the United States to Japan, and Europe, any major central bank targets a two percent inflation rate.

It is normal to do this because an economy that grows at a healthy rate needs a specific inflation target. For whatever the reason, such a robust rate needs a 2% inflation, according to nowadays central banks.

Let's explain a bit here the economic circle that makes up the need for inflation to be on any central bank's mandate:

  • A higher inflation than the targeted level leads to the economy overheating. That's not good because money will lose value and people will feel savings deteriorate. As such, central banks step in and raise the cost of money, a.k.a. the interest rate level.
  • The further inflation goes, the higher and faster the central banks will raise the rates. Virtually, there's no limitation, in theory.
  • A lower inflation, however, has limitations. The reason for this comes from the 'limited' distance the inflation has for reaching the zero level. Basically, this is a two percent distance.

Consequently, while central banks do have resources to fight inflation, they need to get 'inventive' to combat the ugliest sister: deflation.

Introducing Deflation

Deflation represents the scary part of any society. Its implications and roots go so thick in the way a society acts, that central banks find it difficult anymore to control the value of money.

Here is why deflation is a higher risk than inflation:

  • Imagine you want to buy yourself the last 4K television set. For the sake of an example, let's assume it costs $1000. As such, you decide to go to the shop or to shop online for it.
  • However, to your surprise, you find out the price dropped 10% in the last month due to heavy promotions. Now, what if it will fall with another 10% in the next month? After all, it isn't a necessity, and you can easily wait for another thirty days.
  • To your even bigger surprise, the price falls by another 10% in the next month. What a deal, huh?

In reality, while it may be a deal for you, it is a bad sign for an economy. The more the consumer delays the buying, the bigger the store inventories will be.

Therefore, it won't give orders to factories. Without orders, factories will start laying off people, which will increase the unemployment rate. This, in turn, will lead to the government having higher unemployment costs, and will affect the general budget, with the potential of a deficit to rise.

To avoid that, something must be done. Entering central banks.

Central Banks in Fighting Deflation

Fighting deflation means a single thing: easing the monetary policy. When easing starts, central banks won't stop until the process reverses and inflation appears again.

Some banks appealed to negative interest rates. The European Central Bank (ECB) and the Swiss National Bank (SNB), both still have their rates in negative territory. That's a negative for the currency.

The Fed, on the other hand, didn't move the rates below zero, but it engaged in four quantitative easing programs that were destined to stimulate the economy. When it succeeded, the easing stopped, and normalization started.

On the other hand, in Japan, deflation gripped the economy for over two decades. No matter what the central bank did, Bank of Japan wasn't able to bring inflation to the target.

As you can see, all these examples show why deflation is difficult to treat and why currencies react differently to it in various parts of the world.

While inflation triggers the same result from central banks around the world (raising the interest rate, hence bullish for the currency), deflation ends up being treated differently, with other factors (e.g., demographics, economy size, unconventional measured moves, etc.) influencing the outcome.

Fighting deflation results in a lower currency and examples are all over the place. When Bank of Japan started to directly buy bonds from their own government (in one of the boldest moves to fight deflation), the JPY fell across the board.

When the ECB acknowledged inflation is melting due to the sharp fall in oil prices, the Euro fell against almost all currencies, with the best example coming from the EURUSD pair - it dropped like a rock, from above 1.40 to almost parity.

Conclusion

From an economic point of view, inflation and deflation represent two evils. But, between the two, the necessary one, inflation, must appear as a sign things move in the right direction.

Central banks took careful steps in recent years to control prices as much as possible, as one of their major tasks deals with price stability. Automated trading made things even worse, as trading algorithms buy and sell thousands of trades per second or less, and thus it is very difficult for the FX market to move.

On top of this, the recent crypto-mania drew much of the attention of the retail traders, so the sparkling game doesn't seem to be FX anymore. Make no mistake this is just an illusion.

When central banks will be done with fighting deflation, prices will fly and interest rates will rise. Normalization will bring back volatility, and the smartest traders position themselves earlier so that they benefit the most out of the upcoming trend.


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CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

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