Learn Forex Trading: Major Currency Pairs and Investment

What Are Your Options?

Currency Pairs and Investment Vehicles 

There are perhaps 160 different currencies in the world. While all currencies necessarily have exchange value, the majority of them are not exchanged outside of the territories where they are used. The Continuous Linked Settlement Bank (CLS) settles trades in only 17 currencies, and liquidity is greatest for an even smaller group of selected currencies. These so-called major currencies account for more than 90% of global foreign exchange volume and tend to be characterized by tight spreads and excellent liquidity. Expanding this group to include 20 or so exotic currencies can account for more than 97% of overall volume, as shown in Figure 2-1.  

Figure 2-1. Major and exotic currencies, percent of overall trading volume: 2001–20101

Just like stocks have ticker symbols, currencies have three-letter abbreviations, known as ISO (International Standards Organization) codes, which simplify the quoting and trading of currencies. As you can see from Table 2-1, ISO codes tend to be self- explanatory. 1

Table 2-1. ISO Codes for Major and Exotic Currencies

The total sum is 200% because every currency trade always involves two currencies. Remember that currencies fluctuate relative to other currencies, and that they must necessarily be traded in pairs. There are hundreds of potential currency combinations involving the 30 most popular currencies, but less than 100 pairs dominate trading in mainstream investment channels. Most retail forex brokers offer about 50 pairs.

There are a few reasons for this. First, most exotic currencies are traded only relative to major currencies, rather than against other exotic currencies. You would never see a quote for the Czech koruna against the Thai baht, though both currencies can easily be exchanged for euros or US dollars. That’s not to say that Czech companies and individuals have no way to exchange koruna for baht, but rather that volume is too small for international broker-dealers to profitably maintain a liquid market. Second, the forex market is governed by the rule of triangular arbitrage, which dictates that for a set of three currency pairs, only two of them can fluctuate independently. For example, consider the following three currency pairs: dollar/euro, dollar/yen, and yen/euro. If the dollar rises by 1% against the euro, and the dollar stays flat against the yen, the yen must necessarily rise by 1% against the euro in order for market equilibrium to be maintained. These days, computerized trading systems can spot even the smallest discrepancies, and arbitrage them away in mere milliseconds.

Besides, it has historically been the case that exotic currencies fluctuate relative to the dollar, euro, or other major currencies. There simply isn’t enough bilateral trade or cross-border investment between the Czech Republic and Thailand for the market to be able to determine a reasonable exchange rate between their respective currencies. Instead, both currencies will trade relative to the US dollar, and triangular arbitrage will dictate the cross rate for the koruna/baht (CZK/THB). For investors that nonetheless want direct exposure to CZK/THB, the investment process is fairly straightforward. By buying the USD/THB and simultaneously selling the CZK/USD, the result is a synthetic CZK/THB position:

US Dollar

The US dollar (or Greenback) is easily the world’s most important currency. The relative strength of the US dollar is largely attributable to the facts that US economy is the largest in the world and its capital markets are the deepest and most liquid. Some also attribute the dollar’s strength to political/military factors, while others consider it an outgrowth of the old Bretton Woods System. Regardless, the US dollar is the fulcrum of the forex markets, and all other exchange rates are based in large part on market participants’ perceptions of the dollar.

In addition to its status as the world’s most important currency, the US dollar is also the most liquid, and so it is unsurprising that it serves as the world’s de facto reserve currency. In fact, roughly 65% of the world’s reserves are denominated in US dollars, and as a result, central banks around the world collectively hold many trillions of dollars worth of currency on their balance sheets. From time to time, central banks will agitate for a new system that would leave them less exposed to a sudden devaluation in the US dollar. For a variety of reasons, however, they haven’t made much headway in this quest. It can be seen from Figure 2-2 that the US dollar is represented in the overwhelming majority of forex transactions.

 

Figure 2-2. Breakdown of forex volume by currency pair

As I explained in Chapter 1, the US dollar’s defining feature is that it is a safe-haven currency. During times of global financial, economic, or even political uncertainty, the underlying value of the dollar will rise. This point was underscored during the height of the global credit crisis in 2008-2009. Even though much of the financial distress originated within the United States (i.e., the bankruptcies of Lehman Brothers and Bear Stearns, falling real estate prices, etc.) the US dollar appreciated in value. That’s because investors from the United States and around the world were suddenly overcome with fear, and moved their cash to what is perceived as the world’s safest location: US government securities. That the US financial system was in many ways the source of instability was bizarrely of no concern to the forex markets! In addition, whether or not Treasury bonds are actually a good investment is certainly open to debate. What’s important is that they are perceived as the safest investment in the world, a general sentiment that is made clear every time there is even a minor crisis in the financial industry.

To be sure, the US dollar looks vulnerable on a number of fronts. As this book goes to press, the US economic recovery remains precarious, and a second recession is not out of the question. The unemployment rate is still high, interest rates remain low, housing and stock prices are plummeting, and commodity prices are rising. While the trade imbalance seems to have stabilized, it is nonetheless tilted heavily towards deficit.

Some commentators argue that there is a glut of dollars in the money supply as a result of two Federal Reserve Bank monetary stimulus programs. Left unattended, this could lead to an inflationary surge. Meanwhile, both public and private debts continue to reach record levels, and the US sovereign credit rating was downgraded from the highest level of AAA in 2011. Due to previously unseen levels of political infighting, federal and state governments seem incapable of putting the United States on a sustainable economic course. For this reason, there are a number of bears that insist the period of dollar hegemony will soon come to an end.

For now at least, however, the dollar seems likely to hold on to its position atop the forex markets, if only because of a lack of viable alternatives. (The Wizard of Omaha Warren Buffett famously lost more than $1 billion in 2005, when he bet on a long-term decline of the dollar.) As we’ll see later, most other major currencies are racked by the same financial and economic problems as the dollar. Emerging market economies represent the future of the global economy, but it will still be many years before their currencies can challenge the dollar and the rest of the world’s major currencies.

Euro

The euro was introduced in 1999 and entered circulation in 2002. As of 2012, it has replaced 20 separate sovereign currencies, including the deutsche mark and French franc. The Eurozone is the world’s second largest economy, and the euro is easily the second most important currency.

The euro owes its existence both to political and economic forces. It was intended to further unify the European Union by eliminating the need for currency conversion within its borders. Moreover, it was deliberately engineered to be stronger than the US dollar (i.e., one euro is worth more than one dollar), and has remained quite strong since its inception. From 2002 to 2008, it appreciated by more than 70% against the dollar, and many currency investors netted a healthy profit. For both political and economic reasons, it has gained widespread acceptance as an alternative to the US dollar. This is displayed in Figure 2-3.

Figure 2-3. Complete history of EUR/USD

After peaking at $1.60 in 2008, however, the euro entered a period of decline. The first punch came in the form of the global credit crisis, which froze the European banking system and required significant intervention by the European Central Bank (ECB). Then came the revelation that some of the peripheral members of the European Union had overextended themselves and were teetering on the verge of bankruptcy. Greece, Ireland, Portugal, and Spain have all received financial support from the European Union and the International Monetary Fund (IMF), but investors remain skeptical that these countries can avoid defaulting on their debt. These countries have experienced repeated cuts in their sovereign credit rating and skyrocketing borrowing rates, and at this point, the vicious cycle of economic decline and cuts in government spending seem to make default a self-fulfilling prophecy.

The ultimate concern is that other EU economies will become engulfed in the storm, and that the European fiscal crisis will morph into a full-blown financial crisis. The reason being is that European banks lent heavily to the so-called PIGS countries (Portugal, Ireland, Greece, and Spain) during the economic boom years, and would certainly collapse if one or more of these countries defaulted on their debts. The extent to which foreign banks are exposed to Eurozone debt default is displayed in Figure 2-4.

Figure 2-4. Foreign banks’ exposure to Eurozone debt defaul

In hindsight, it looks as though the original case for monetary union of the Eurozone was overstated. The Eurozone economies are simply too different from one another for their monetary unification to be justified. Furthermore, unifying under the umbrella of a common currency stripped them of their ability to carry out independent monetary policies, but did not similarly mandate a common fiscal policy. This sowed the seeds for extreme imbalances: during the boom years, low interest rates promoted overheating on the Eurozone periphery. These economies have been hit disproportionately hard by the bust, and without currency depreciation—rendered impossible by the euro—they have very few prospects for recovery. In short, the luster of the euro has been dented severely. It remains possible that the ten-year common currency experiment will soon come to an end.

Japanese Yen

The Japanese yen is perhaps the world’s best performing currency of the modern era, having strengthened by 400% against the US dollar since 1971! (See Figure 2-5.)

Figure 2-5. Recent history of USD/JPY (with exchange rate shown in reverse)

Initially, the yen’s resurgence was due to a post-World War II economic boom in Japan that lasted well into the 1980s and culminated in Japan’s emergence as the world’s second largest economy. (It has since been eclipsed by China in 2010.) Ultimately, however, this boom proved unsustainable, and Japan’s economy has stagnated for the better part of two decades. The same can also be said of its stock market.

What has saved the yen from the same dubious fate is Japan’s export sector. Up until 2009, Japan had recorded a trade surplus (where exports exceed imports) for more than 30 consecutive years! This is especially amazing when you consider that Japan lacks natural resources and relies almost entirely on deposits in other countries to satisfy its needs for energy and other commodities. In addition, price inflation (which directly erodes the value of money) has been virtually nonexistent in Japan. Even though Japan’s public debt is the largest in the world (on a per-capita basis), it is financed entirely from domestic savings. Finally, Japan’s financial system is as sophisticated as any in the world and continues to attract strong investment. All of these forces ensure that demand for yen continually exceeds supply.

For most of the 2000s, the yen suffered a mild decline due to record low interest rates in Japan that enabled opportunistic investors to borrow in yen and use the proceeds for high-yielding investments abroad. This caused a massive outflow of yen from Japan. However, this phenomenon came to an end in 2008 when investors got spooked and moved to unwind all of their short bets on the yen. Ironically, the March 2011 tsunami/earthquake only accelerated this trend, and the repatriation of yen to fund reconstruction and insurance payouts has even further provided support for the currency. Even a historic joint intervention by the world’s largest central banks was unable to stop the yen from surging toward record highs.

British Pound

The pound sterling (or cable) was the strongest currency in the pre-World War II era. Despite ceding this title to the US dollar, it has managed to remain the fourth-most traded currency in the world, which is due in no small part to London’s position as the world’s preeminent currency trading center.

The British economy largely mirrors that of the United States. It has been hollowed out by the shift of manufacturing to developing countries, and has been plagued by a perennial trade deficit. Unemployment and inflation levels are consistently among the highest in the industrialized world. Its housing market is still weak and may not recover for several years. UK public debt more than doubled from 2007 to 2011, which the Bank of England enabled by printing money on a never-before-seen scale following the 2008 economic downturn.

After a record run-up, the pound collapsed in the fall of 2008, depreciating by more than 30% from peak to trough. The UK government has yet to produce a coherent plan for exiting from recession, and four years later, the pound is still referred to as a “sick” currency.

Swiss Franc

Without knowing anything about the Swiss franc, there are already a few prima facie observations that can be made. First, the Swiss franc has proven itself to be an excellent store of value, especially relative to the US dollar. Second, the value of the Swiss franc has closely mirrored that of the euro, as can be seen in Figure 2-6.

Figure 2-6. Swiss franc / euro correlation

The Swiss economy is one of the most stable in the world, and on a per-capita basis, Switzerland is the world’s second wealthiest country (not including city-states), trailing only Norway. It boasts low unemployment and low inflation. Its trade surplus has expanded in spite of the rising franc thanks to key exports, such as jewelry (including watches), textile machines, chemicals, and tobacco products. The Swiss National Bank (SNB) has helped the overall health of the Swiss economy with a conservative monetary policy; it was one of the few major central banks that refrained from printing money during the credit crisis.

In some ways, the Swiss franc is the world’s ultimate safe-haven currency. Whenever there is a flare-up in financial uncertainty, the franc typically rises more than both the Japanese yen and US dollar. This is perhaps due to the fact that the Swiss economy and financial markets are not large enough to absorb massive amounts of capital inflows without exerting upward pressure on the franc.

As for the Swiss franc’s historic correlation with the euro, as shown in Figure 2-6, the Swiss and Eurozone economies are closely intertwined. Thus, it should come as no surprise that for most of the euro’s existence, the two currencies have moved in tandem with one another. With the inception of the credit crisis, however, investors began to see the franc as a proxy for betting on the stronger members of the Eurozone (Germany, France) without the baggage from the weaker members that comes with owning the euro. The benefits of Swiss neutrality (it is a member of neither the European Monetary Union nor the G7 and was one of the last countries to join the United Nations) have trickled all the way down to the franc.

In 2009, the SNB undertook a serious effort to prevent the franc from rising, and it even managed to hold the franc at €1.50 for several months. This can be seen in Figure 2-7. The upward pressure on the franc instead found an outlet in the CHF/USD, which rose by a whopping 60% from 2009 to 2011! The franc eventually broke through the barrier with the euro, rising to a record high and costing the SNB more than $20 billion in losses. In September of 2011, the SNB shocked the markets when it resumed its campaign and announced that the franc would not be permitted to rise beyond €1.20.

Insert Figure 2-7.

Figure 2-7. Rising franc (shown in reverse) and SNB intervention

Canadian Dollar

The Canadian dollar (or Loonie) is one of a handful of major currencies that correlates closely with commodity prices. Canada is one of the world’s major producers of petroleum, electricity, timber, and certain agricultural products. Thus, the commodities boom that began in the 2000s and picked up again in 2010 coincided with a steady rise in the Loonie, which breached parity (1:1) against the US dollar for the first time in 30 years. This can be seen in Figure 2-8.

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Figure 2-8. Recent history of CAD/USD

Ultimately, the most important facet of Canada’s economy is its relationship with the United States. Canada is the most important foreign supplier of oil, natural gas, and electricity to the United States. Moreover, the United States absorbs around 75% of all Canadian exports. Thus, the economic fortunes of Canada hinge closely on those of the United States, and so it should come as no surprise that the economic downturn in the United States, combined with a soaring Loonie, hit Canada hard. In 2009, the balance of trade shifted towards deficit, and reports of cross-border shopping trips by deal-hunting Canadians have since abounded in the news media. Some commentators wonder whether the Loonie really deserves to trade at parity with the dollar.

Australian Dollar

The correlation between the Australian dollar (or Aussie) and commodities prices is perhaps the strongest among the so-called commodity currencies, as can be seen in Figure 2-9. In fact, Australia is among the world leaders in the production of coal, iron ore, and other precious metals. Thanks to these vast resources of energy and commodities, supported by interminably growing demand from China, Australia managed to emerge from the global financial crisis virtually unscathed.

 

Figure 2-9. Correlation between AUD/USD and commodities prices

There are a couple of other observations that can be made about the Australian dollar. First, Australia’s economy is closely tied to that of Asia—the destination for the majority of its exports—and especially China. As the Chinese yuan is pegged to the US dollar (more on that later) and Chinese capital markets are somewhat opaque, investors have started to treat the Australian dollar as a proxy for investing in the Chinese yuan. Second, Australian interest rate levels tend to be significantly higher than those in other industrialized countries. The Reserve Bank of Australia’s (RBA) benchmark rate touched 7.25% in 2008, and was held above 3% during the depths of the global financial crisis. When investor risk appetite is high, then, Australia typically experiences an influx of speculative capital from investors seeking to take advantage of relatively high interest rates.

New Zealand Dollar

The New Zealand dollar (or Kiwi) is influenced by the same key economic factors as the Australian dollar; namely, high GDP growth, high inflation and interest rates, and a reliance on commodities as a driver of economic growth. Instead of metals and energy, however, New Zealand is a leading producer of dairy products and agricultural staples. Due to these factors as well as mere proximity, the NZ dollar has historically traded close to the Australian dollar, which can be seen in Figure 2-10. An unfavorable balance of trade and relatively high public debt levels, however, have caused the Kiwi to fall behind in the last several years.

Figure 2-10. Recent history of AUD/NZD