Understanding Monetary Policy: A Guide to Hawkish and Dovish Approaches

Familiarity with terminology used in financial markets is arguably highly important for those investing in financial products. This understanding can assist with both entry and exit decision-making in the context of an individual’s risk profile and objectives. 

Two terms that are often used to describe the overall position of a central bank are “Hawkish” and “Dovish.”

 For traders and investors, understanding the subtle clues in central banks’ communications about their policy stances can be vital, irrespective of their chosen trading or investing approach, as the impact can be far-reaching. Such communications are often released within statements that go along with interest rate decisions themselves, individual speeches from central bank members, and, of course, interpretations and opinions contributed by financial media commentators.

It’s important to note that neither a hawkish nor a dovish stance is universally good or bad. The appropriateness of either approach will depend on specific economic conditions and is always to topic of much debate among the financial community as well as within central banks themselves. 

Other key factors to consider are not only the stance itself but also whether there are changes in the degree to which this is the case, and of course, how well or otherwise this matches current market expectations. 

Irrespective of the detail, the bottom line remains that because of the significant influence of the central bank stance, both in the short and long term, being attuned to these policy shifts and adapting trading strategies accordingly can be a powerful tool for traders. 

The purpose of this article is to describe these terms in a little more detail, their implications for financial markets in the context of the economic changes that may result from either.

Hawkish Policy 

The hawkish stance emphasises the importance of keeping inflation in check and curbing economic overheating, even if it means sacrificing some economic growth in the process. In practical terms, this is often delivered through increasing interest rates, and supporters of a hawkish approach believe that maintaining stable prices creates a more predictable economic environment, considered essential for making informed investment and financial decisions.

Dovish policy

A dovish policy stance is typically adopted by a central bank to stimulate economic growth. It is characterised by a more accommodative monetary policy, and includes lowering interest rates and may even involve putting in other measures to increase money supply in the economy. The main objective is to encourage borrowing and investment, increase consumer spending, and create a supportive environment for employment growth. 

Implications for Financial Markets:

1. Bonds: In an increasingly hawkish status, higher interest rates generally lead to lower bond prices and higher yields. As a result, investors who hold bonds with fixed interest rates might see a decrease in the market value of those bonds.
2. Stocks: Should there be an increasingly aggressive monetary policy, the cost of borrowing increases with higher interest rates, potentially affecting companies’ profit margins, particularly for those companies with higher debt levels. Additionally, the negative impact of a decrease in consumer spending will impact company revenue, particularly in growth and consumer discretionary stocks. These factors will exert downward pressure on stocks as the impact on earnings of both of these factors bites into previously expected EPS. The impact on the housing market will commonly influence the pricing of related stocks, e.g., homebuilders. Whereas with a dovish viewpoint, equity markets are likely to see gains with growth; for example, technology stocks and consumer discretionary stocks may benefit. Companies might increase capital investment in research and development or even be more likely to consider acquisitions, taking advantage of the lower cost of borrowing.
3. Currencies: A hawkish policy usually leads to currency appreciation, making the country’s currency more attractive to foreign investors. The reverse is, of course, true also, with an increasing dovish stance resulting in currency depreciation. 

As currencies are traded in pairs, the implications will be somewhat dependent on more than one central bank policy. 

One final point worth emphasising is that the impact of central bank policy and the hawkish or dovish viewpoint, although mostly impacting on the national economy, is likely to have far-reaching effects beyond the local economy if it is from one of the major economic powers e.g. US. The impact will spread throughout the global financial markets, including, in this case, commodity prices.

Summary

Both hawkish and dovish stances have significant impacts on financial markets and the broader economy. The effectiveness of either approach depends on the prevailing economic conditions and the goals of the respective central bank. 

For traders and investors, understanding the subtle clues in central banks’ communications about their policy stances can be vital. Hawkish signals might lead to short-term rallies in the currency but declines in bond and equity markets, while dovish signals might have the opposite effect. Being aware of these policy shifts, knowing key relevant dates of related events, sand adapting trading strategies accordingly can be a powerful tool for traders and investors alike.