Trading currency wars

March 30, 2017 09:00 AM

A central bank’s control over its country’s currency price is similar to the ability of the U.S. Federal Reserve Bank to manage short-term interest rates. The Fed has plenty of resources available to move the market rate of interest, and any country’s central bank has the same control over its currency’s value relative to other currencies.
The objective of a country’s central bank or other monetary authority is often to make the home country’s currency lower in price than the currencies of its competitors in the world market. With a lower price, the country’s export trade is facilitated, with corresponding positive effects on its economy, productivity and jobs.

“Competing currencies” (below) shows the cumulative percentage price changes for six currencies over 12 months ending at Feb. 1, 2017. This period includes the Brexit vote’s impact on the British pound with a sudden vertical drop in June 2016. Although Brexit gave the British a resounding victory in terms of the currency war objective of achieving the low price currency, there was little response by England’s competitors until after a second decline in the pound in September and October of 2016. 

In November, we saw large declines in the prices of all five competitors: the euro, Swiss franc, Australian dollar, Canadian dollar and Japanese yen. Starting at the time of the Brexit vote, it would have been possible to predict that the other central banks would think about strategies that would enable their currencies to compete with the pound’s lower export prices. 

In that quiet period following the second decline of approximately 7% in the pound, a trader could have taken a short position in any or all of the five competitors and made good profits from mid-November through the first of December.

USD vs. The world

Because the currencies engaged in price war are also components of the U.S. Dollar Index, a trade based on predicting a gain in the dollar would have been profitable. The five competitors of the pound have price changes that are inversely related to the U.S. dollar. Because of the expected response to Brexit, a long position in a dollar exchange-traded fund would have been profitable (see “Dollar Index ETF,” below). The Brexit effect on the U.S. dollar reached a peak at the end of year in 2016 as the competing currencies were able to reduce the gap between their prices and the lower price of the pound. 

Brexit trades will be history once the British pound’s competing currencies are able to lower their prices sufficiently to offset the pound’s temporary low cost advantage. However, the end of Brexit will not signal the closing out of central bank strategies to achieve low price. Currency wars existed before Brexit and will continue to provide trading opportunities as long as countries use their currencies in international economic competition.

Of course, the strategy of each country to reduce the price of its currency is reflective of “beggar thy neighbor” economic policies of the 1930s and before. If demand within a country is shifted from imports to domestic production, its economy is improved and trading partners (including some neighbors) in international trade are worse-off. The most serious recent case of “beggar thy neighbor” is the impact of Brexit on the U.S. dollar, as purposeful declines in other currencies forced the dollar’s international price (represented by the Dollar Index) to higher levels.

Exploiting currency wars

From the viewpoint of a forex trader, currency wars — competition among countries for low price — offer outstanding opportunities with predictable price movements due to expectations based on typical central bank policies. 

“Competing currencies” appears to show relatively quiet movements in price changes for the ETFs of the six currencies before and after Brexit. However, the chart includes several competitions that continue to be managed by central banks and other monetary authorities of countries engaged in battles for low price.

A classic war is one between the Swiss franc and the euro. In 2011, the Swiss instituted a cap (price peg) that mandated the franc would not go above 1.2 euro. Because of the restrictive policy, the two currencies moved together in terms of percentage price changes, since the franc was not letting the euro out of its sight. The tight price changes are shown on “Swiss franc and the euro,” (below) from January 2014 through Jan. 15, 2015. 

On Jan. 15, 2015, the Swiss National Bank said that it was removing the cap of 0.12 Swiss francs to one euro. According to The Economist, a number of hedge funds across the world had large losses due to the announcement and the Swiss stock market collapsed. The reason for removal of the price peg may have been due in part to the large amount of foreign currency that the Swiss had amassed in selling francs to lower their value. By 2014, the SNB was holding about $480 billion in foreign currency — an amount equal to approximately 70% of the Swiss GDP. 

The immediate impact of the announcement ending the Swiss price peg was a price gain in the franc of approximately 10%, which was very favorable to someone long the franc, but terrible for short positions. Those bad hedge funds must have been on the short side of the franc. Following the first change, the prices of the franc and euro moved closely together again as the original spread gradually declined. The Swiss seem to have retreated but did not give up the battle.

A continuation of the Swiss/euro contest is shown on the lower chart of “Swiss franc and the euro.” The chart shows several trading opportunities when the two separate only to come together again. One of the largest spreads is shown at the end of January 2017 — possibly a trade selling the franc and buying the euro — meanwhile looking out for another SNB announcement that it doesn’t matter what the euro does. Until then, we will depend on the Swiss to narrow the gap.

“Close combat: Australia and Canada,” (below) seems to show two currencies at war, but may just indicate their common ties to the British economy. For trading purposes it is enough to know that any gap between the two series of price changes is soon eliminated. 

“Yen for a fight” (below) shows what is probably a real war between the euro and yen, with the yen occasionally ranging far above the other currencies’ prices and then moving back toward competitive pricing. A trader should be able to take advantage of the large spreads created between the Japanese yen and the euro, and also between the yen and Australian dollar (first chart in “Yen for a fight”). 

Price changes are shown by exchange-traded funds because of the comparative ease of obtaining historical price data for ETFs.

ETFs are valuable because their price movements closely shadow the underlying contracts that they represent. 
For each trading opportunity described here, there are choices including cash prices, futures, options and ETFs. 
By observing central bank actions, a trader should have many opportunities, thanks to the currency wars.

About the Author

Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.