The U.S. dollar is the reserve currency of the world and as such, its fundamentals and technicals are paramount in any trade involving it. There are times when some news out of the Fed creates a market spike that takes you out of a trade.
In the last 20 years, the world that was divided politically between the ideologies of democracy and communism has become one, with a few small exceptions. The global financial players have responded to that transformation by sharing one stage and having access to equities, bonds and commodities the world over almost equally and instantaneously.
This brings us to a central place in today’s financial world: currency markets. The spot currency markets are not only central within the global financial system, but they also have become an asset class.
They offer great opportunities to traders and asset allocators alike with uninterrupted trading from 5 p.m. EST on Sunday in New York until the same time on the following Friday. The inter-bank currency markets, long a domain of large banks, hedge funds and professional speculators, in 2001 welcomed small investors.
Many banks and futures commission merchants (FCMs) made it possible for investors with a few thousand dollars to trade their accounts by offering electronic trading platforms with multiple currency crosses. The currency markets are not linear. Crosses of the U.S. dollar vs. major currencies are certainly an intricate, most liquid, very important component of the forex markets, but many other pairs offer great opportunities, if one understands their response, and their behavior in relation to different multiple events taking place continuously within the global financial markets. There has never been a time in recent financial history when equities, bonds, commodities and currencies have been so intertwined and accessible with the Internet, allowing the traders to react to markets with one click of a mouse.
Many traders exclusively trade U.S. dollar versus G-7 currencies, and by this not only give up many opportunities in other crosses, but limit their playing field.
The currencies at their core are driven by interest rates, local economies and flow of funds in or out of that individual currency zone. There are a few basic differences between trading major crosses and crosses of other currencies also called exotic crosses. The liquidity in exotic currencies is certainly lower, which translates to wider spreads.
For example: while EUR/USD or USD/JPY may have spreads between bid and offer from choice (no spread) to one to two pips, traders should expect spreads in exotic currency crosses from three to 10 pips, depending on the time of the day, which is directly linked to liquidity and depends on the spreads the dealer offers. However, the major cross pairs like EUR/JPY are quite liquid.
That also means that the costs of the trade are much higher when one has to buy/sell with seven-pip spreads. Traders based in different time zones have to be cognizant of the liquidity in the markets and upcoming economic numbers in that currency zone and be prepared for significant volatility during that time.
By trading a wide range of currency crosses, traders may be able not only to diversify within forex markets but also have an opportunity to establish positions that to some extent can offset each other. However, trading multiple crosses resulting in many open positions creates other problems if one is not versed in the markets and should only be done by experienced traders.
The pound sterling has an interesting relationship with the dollar and euro and its own unique fundamentals. There are a couple of instances in the last six months when a bullish position in the pound vs. the dollar would have been a loser, but a major winner against the euro. While the fundamentals of the dollar and euro probably were the major drivers, if the only way you could play the pound was vs. the dollar, you had no chance to take advantage of the pound’s outperformance of the euro (see “Pounding the euro”).
There are a number of crosses that are quite popular with traders and do not involve the greenback. One of the most popular, very widely traded is Japanese yen vs. G-7 currencies.
In so-called carry trades, Japanese yen vs. higher yielding currencies (Australian, Canadian and New Zealand dollar or the euro), traders are selling short yen and buying other currencies for a positive spread in interest rates. For example, in 2004, Japanese interest rates were close to zero and the Australian dollar was at 7.25%. Essentially, the trader was being paid handsomely by borrowing in Japan and depositing his funds in Australia.
Carry trades are not only a way to capture interest rate differentials, but also a vote for or against risk as it was quantified in the financial world. During the height of the financial mania in 2008, with the risk being priced in relation to U.S. Treasuries at negligible levels, EUR/JPY was trading close to 170 yen, and the Australian dollar vs. yen was at 105 yen.
The traders not only got paid with higher interest rates, but also through capital appreciation. Carry trade crosses reversed violently when the financial crisis hit in September 2008 and AUD/JPY went from 105 to 55 EUR/JPY from 170 to 114, GBP/JPY from 251 to 118 (see “Carrying charges,”).
In addition to interest spreads that ballooned between Treasuries and junk bonds, nothing reflected extreme fear in the markets better than the carry trades collapse. Another very interesting group of currencies is commodity currencies: Australian, Canadian and New Zealand dollars, Brazilian real, South African rand and Russian ruble. These countries are major exporters of commodities and their currencies respond to strength or weakness of global economies accordingly.
While yen crosses are mainly speculative plays based on risk aversion or lack of it within the financial markets, commodity currencies offer a look not only at rate differential, but also capture fundamental differences in their economies and global economic zones that they are part of. Euro vs. Aussie dollar offers a trade in a cross that represents Europe, an “old world” very much ingrained in Western culture, and Australia, which is located in close proximity to China, India, Indonesia and Japan and benefits from the insatiable appetite of those countries for commodities. Prior to the implosion of global equity markets in September/October 2008, EUR/AUD was trading above 2.10, which means it took more than two Australian dollars to buy one euro. In spite of 350 basis points in interest rates in favor of Aussie, the emergence of Asia as an economic behemoth, and the less complicated political structure, demographic and economic advantages of Australia over the quite fragmented, complicated Eurozone’s bloc of countries, the market was pricing that cross at least 20% higher than it deserved. As the crisis hit Europe and the United States greatly, its influence on Asia and Australia was much tamer, and short-term interest rates that eventually went to zero in the U.S. and 1% in Europe stopped at 3.5% in Australia.
The Reserve Bank of Australia was the first major central bank to raise interest rates. That is why EUR/AUD was trading at 1.60 at the beginning of 2010, and with the Greece/Portugal/Spain/Ireland sovereign crisis in full bloom, the same cross is presently priced at 1.49 (see “Sliding euro,”).
These examples show that diversification and the ability to trade many other crosses in addition to majors can offer tremendous opportunities for profit. However, one has to understand that trading risks may be higher, costs of transactions may be greater and there may be somewhat different volatility, which translates into wider daily trading bands.Every trader needs to work these factors into their model. If you are trading a short-term strategy that assumes you can get in and out of the market with a one or two pip spread, you can’t simply go from trading the EUR/USD to the EUR/AUD.
From a trader’s perspective, it may mean establishing smaller positions, wider stops and a more patient approach, because of all of the above. Trading all of the currencies requires complete understanding of the risks involved and the fundamental and technical factors driving forex markets. But there are benefits from widening your horizons, especially in currencies, where the fundamentals of the dollar can overwhelm the fundamentals of the specific currency you are looking at.
Marek D. Chelkowski is a CTA based in Meridian, Idaho. He is a discretionary trader who exclusively trades spot currency markets.