​Coronavirus crash: how could central banks drive FX markets?

With central banks gearing up to act in the event of a coronavirus economic crunch. How could this impact the FX markets?

The coronavirus crisis has had a profound effect on stock markets last week, with the Dow Jones currently heading for the seventh worst week of trading in history.

The basis for such a move is relatively obvious, with the global spread of the virus raising fears that the Wuhan experiences could be replicated throughout the Western world. That means the potential for a lockdown on the movement of people and in turn, goods.

The knock-on impact for stocks is clear, with containment efforts providing a massive supply-side squeeze as businesses close. However, the demand for specific industrial would also take a hit as travel and tourism grinds to a halt.

From a forex perspective, traders will look for those economies that are hit the hardest.

Any country that is hit particular hard by the virus and economic impact would likely see their currency come under attack. However, we also need to consider the potential monetary policy implications of any economic downturn.

Will the Fed lead the way lower?

We are gradually seeing central bankers provide commentary over their role in any such downturn. With the Federal Reserve (Fed) rates significantly higher than the likes of the Bank of England (BoE) and European Central Bank (ECB), markets are already pricing in a 44% chance that the Fed will act early and cut rates at their forthcoming meeting (18 March).

There are huge questions over the logic behind central bank attempts to resolve a supply-led crisis with demand-focused policy tools. Ultimately, a health-related economic crisis is not going to be resolved through lower interest rates.

Nevertheless, the FX markets would pay close attention if one central bank takes disproportionately greater action that another. The ECB has noted that they would be willing to act if necessary, while the BoE is less certain given the changing leadership underway.

The graph below highlights the interest rate differentials between some of the major economies.

One country that catches the eye is Canada, with the sharp decline in oil prices raising the prospect of a double-whammy impact if the virus spreads throughout the country. Currently there have been just 14 coronavirus cases in Canada.

Nevertheless, the weekly chart below highlights the bullish breakout we have seen this week for USD/CAD, with the rise through trendline resistance and $1.3382 signalling the potential for a resumption of the bullish trend seen in 2018.

Another market of interest is India, with fears over how effective measures to contain the virus could be in a nation that has such overpopulation in major cities.

Yet again, we have seen precious few cases in India, yet a spread throughout India could see traders look towards the INR as a potential currency to short given the currently elevated interest rates.

The weekly USD/INR chart highlights the bullish breakout seen this week, with the six-month consolidation phase seemingly over. There is a good chance we will see further upside from here, with this breakout signaling a likely continuation of the 2018 uptrend.

Ultimately, this is a longer-term outlook where potential monetary policy shifts could drive market sentiment in the event of an escalation of this current coronavirus crisis. It is worthwhile noting that those currencies with higher interest rates would ordinarily provide carry-trade benefits as traders are paid to hold that currency. However, with risks rising, havens come into focus and those carry trades become unwound.

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