You may have heard a financial news anchor say something like “The central bank governor took a somewhat hawkish stance today following strong economic data.” The terms “hawkish” and “dovish” refer to whether central banks are more likely to tighten (hawkish) or loosen (dovish) their monetary policy.
The policymakers at central banks determine whether to raise or lower interest rates, which has a significant impact on the foreign exchange markets. Policymakers raise interest rates to cool an overheating economy (to prevent inflation from rising too high) and lower rates to stimulate the economy (to prevent deflation and promote GDP growth).
Hawkish and dovish policies affect currency exchange rates through a mechanism that central bank governors like to call “forward guidance.” This is where policymakers try to be as transparent as possible in communicating the direction of monetary policy to the markets.
Read on to learn more about hawkish and dovish policies and how to apply this knowledge to your foreign exchange trading.
What does HAWKISH mean?
The term hawkish is used to describe a tightening monetary policy. Central bankers can be said to be hawkish if they talk about tightening monetary policy by raising interest rates or reducing the central bank’s balance sheet. A monetary policy stance is said to be hawkish if it predicts that interest rates will rise in the future. Central bankers can also be said to be hawkish when they are optimistic about the outlook for economic growth and predict that inflation will rise.
Currencies tend to move the most when central bankers shift their tone from dovish to hawkish or vice versa. For example, if a central banker recently took a dovish stance, saying the economy still needs stimulus, and then in a later speech says they have seen rising inflationary pressures and strong economic growth, you may see the currency rise against other currencies.
Some words that might be used to describe hawkish monetary policy include:
- Strong economic growth
- Inflation is rising
- Reduce balance sheet
- Tighten monetary policy
- Interest rate increase
In general, the words used suggest rising inflation, higher interest rates and strong economic growth, which lean towards a more hawkish monetary policy outcome.
What does DOVISH mean?
Dovish refers to the opposite. When central bankers talk about cutting interest rates or increasing quantitative easing to stimulate the economy, they are said to be dovish. If central bankers are pessimistic about economic growth and predict that inflation will fall or become deflationary and they signal this to the market through their forecasts or forward guidance, they are said to be dovish about the economy. Some words that can be used to describe dovish monetary policy include:
- Weak economic growth
- Deflation/disinflation (negative inflation)
- Increase balance sheet
- Loosening monetary policy
HAWKISH VS DOVISH Explained
The graphic below provides a snapshot of the key differences between hawkish and dovish monetary policy.
The table below provides a more in-depth comparison of dovish versus hawkish monetary policies, highlighting the differences between the two policies and how they impact currencies.
| HAWK MONETARY POLICY | MODERATE MONETARY POLICY |
|---|---|
| Raise interest rates to prevent inflationary pressures → Currencies may appreciate as capital flows into currencies with higher interest rates | Lower interest rates to stimulate the economy → Currencies may depreciate as capital flows into currencies with lower interest rates |
| Reduce the Federal Reserve’s balance sheet by selling mortgage-backed securities (MBS) and Treasury bonds → The currency could appreciate because selling Treasury bonds and MBS could increase interest rates | Increasing the Federal Reserve’s balance sheet through quantitative easing (QE). QE is the purchase of MBS and Treasury bonds to increase the money supply in the economy to stimulate the economy. → Currencies can lose value when the increased money supply reduces the demand for currency |
| Guidance from central banks includes positive statements about the economy, economic growth and inflation outlook. → Currencies could gain as investors expect interest rates to continue to rise | Guidance from central banks includes negative statements about the economy, economic growth and signs of deflation. → Currencies may depreciate as investors anticipate interest rate cuts |
How to Trade When Central Banks Are Hawkish and Dovish
A small change in tone from a central banker can have serious consequences for a currency. Traders often watch Federal Open Market Committee meetings and minutes for small changes in language that could suggest further interest rate hikes or cuts, and try to capitalize on them.
Monetary policy standing as at 1 January 2019
The image above shows the current monetary policy stances of different central banks. As a central bank’s monetary policy stance shifts further to the left (dovish), its currency may depreciate relative to other currencies. As a central bank’s monetary policy stance shifts further to the right (hawkish), its currency may appreciate. Trading a hawkish or dovish central bank is not as simple as buying the currency of the hawkish central bank or selling the currency of the dovish central bank. It involves changing interest rate expectations. Let’s look at two scenarios:
Scenario 1: If a central bank is currently in a rate-hiking cycle, the market will anticipate future rate hikes. The trader’s job is to watch for clues and economic data that could change the central bank’s tone to something more hawkish than it is now or more dovish. Currencies can move a large amount when the monetary tone changes from what it is now.
Scenario 2: Similarly, if a central bank is cutting rates now and economic data is deteriorating, the market will pre-price in the current dovish monetary stance. Traders will have to watch the central bankers’ forward guidance and economic data, which you can find on the economic calendar, for clues as to whether they might become more dovish than they are now or more hawkish. The Federal Reserve was quite hawkish in late 2018. Federal Reserve Chairman Jerome Powell stated that “we are a long way from neutral at this point,” which the market took as hawkish (October 2, 2018). This implied that the Federal Reserve would still have to raise rates several more times to reach the neutral rate. Then, on November 28, the FOMC released its monetary policy statement, in which Jerome Powell said that he saw interest rates as “just below neutral.” This change in tone is similar to scenario 1 above, where central banks shift their tone from hawkish to slightly dovish. This leads to a depreciation of the currency – see the charts below showing what happened to the Dollar Index (DXY) on October 2, 2018 and then again on November 28, 2018. October 2, 2018 – Federal Reserve Chairman Jerome Powell says “We’re a long way from neutral at this point” which leads to a rise in the Dollar.
US Dollar Index 15-minute chart, vertical line for October 2, 2018.
On November 28, 2018, the Federal Reserve Chairman said interest rates were “just below neutral,” signaling a change in tone from hawkish to dovish. The dollar fell.
US Dollar Index 15 Minute Chart
Keeping up to date with central bank news can be difficult. At APM, we have a weekly Central Bank Webinar where we analyse central bank decisions and keep you updated on central bank activity.
If you are just starting out on your trading journey, it is essential to understand the basics of forex trading in our Forex Beginners guide.
