part0054

With almost 200 countries and independent states in the world, each with their own currency, deciding on which currencies to trade and when, can be a daunting task. In fact, the problem is far worse than this, since in forex trading, each currency is then quoted against another, resulting in literally thousands of currency pairs covering all the possible combinations.

But don’t worry. Help is at hand, and in this chapter we are going to focus on those currencies and currency pairs, which are the bedrock of the forex market.

At this point, I feel it is both appropriate and relevant to explain how the forex market has changed over the last few years. The catalyst for this was the financial turmoil, triggered in 2007 by the sub prime mortgage crisis which sent world economies into a steep decline, and ultimately deep recession. Banks such as Lehman Brothers and Bear Sterns collapsed, as the true extent of the crisis unfolded. In Europe, the situation was so severe several countries came close to bankruptcy, only saved by the intervention of the European Central Bank.

What effect has all this had on the currency markets?

The simple answer is dramatic. This is not the book where I propose to cover this in detail. I have written other books on this subject, but I wanted to touch on it here, and the main drivers of change have been the central banks of the United States, Europe, Japan and other major economies around the world. What each of these has done in different ways, is to distort the currency markets by effectively printing money using a process referred to as quantitative easing. You can think of this as increasing the amount of currency in the market, which helps to drive some much needed inflation into ailing economies. It is a blunt instrument at best, with indeterminate results.

Secondly, the banks have been forced to lower interest rates to low, or ultra low levels, in an attempt to stimulate growth in otherwise stagnant economies. This has led to what has been dubbed the ‘race to the bottom’. In other words, each country’s central bank deliberately attempting to maintain a low interest rate, which in turn helps to protect its export market. This is particularly true of major exporters such as the US, Japan and China. This sequence of events has distorted what was once a system of ‘free floating’ exchange rates, and is a feature which is set to continue for years to come. It is a fact of life, and one we have to live with as traders.

There is nothing we can do about the situation, except to recognize the fact that the foreign exchange markets have been drastically distorted by the events of the last few years. They will return to ‘normal’ within the next five to ten years, as the effects of the financial crisis start to wane, but for the time being, this is the situation, and one we have to accept. If you were starting your trading journey in the forex market ten years ago, life would have been very different. I am not suggesting it was ever easy, far from it, but the word I would use here would be ‘predictable’.

The financial crisis has removed that ‘predictability’ from the currency market in many different ways, and not least in the various attempts by central banks to both protect, and stimulate their own economies. This is what I meant in the last chapter, when I referred to the paradox of the forex market. On the one hand it is global, and yet on another it is very local. Central banks will do anything and everything in their power to protect their own economy first . It is very much a case of ‘I’m all right Jack’. We see this every day, and interest rates and quantitative easing are all part of this distortion. Add in the politics of Europe and the major economies of the world, and it becomes a witch’s brew. Even the fundamental news has lost that predictable element.

And it’s not just in the currency markets themselves these changes are having an effect. The bond markets have been the vehicle used by the central banks for currency creation, as they buy bonds in ever increasing quantities. At some point this will cease, but as this is ‘new territory’ for the central banks, no one knows what the long term effects will be, once these programs are tapered and cease. Least of all the banks themselves. All of this will play out in the next few years in the currency markets, and as forex traders, we have to be aware of these forces. The ‘predictability aspect’ of trading in currencies has gone. It will return, but not for many years, which is why volume becomes a key tool in our trading armory. It is one of the few indicators, which when combined with price, truly reveals what is happening as a currency moves higher or lower. Volume and price reveal the truth behind the move, which is why it is so powerful, and perhaps even more relevant today than ever before.

The above comments are not designed to frighten or worry you, they are simply a statement of fact. Things have changed and I would be doing you a huge disservice if I did not make this clear from the start. It’s something to be aware of, and accept, and as you will see later, these changes have also led to changes in the focus on which currency pairs to trade.

Let’s get started then, as I explain each currency, why it is important, and the associated currency pairs we will consider for the remainder of this book.

The US dollar is the number one currency in every respect. The US economy is the largest in the world, and although set to be overtaken by China in the next decade, remains the most important at present. The US dollar is referred to as the currency of ‘First Reserve’, simply because every bank around the world will have the largest percentage of their foreign exchange reserves held in US dollars. And the reason for this is simple. The US dollar is seen as safe. The dollar underpins the largest economy in the world, is backed by the US Federal Reserve, and since the demise of the Bretton Woods gold standard, has been adopted as the currency of first reserve. In addition, the US dollar lies at the heart of the largest debt market in US bonds. Finally, all commodities are also priced in US dollars, including both oil and gold.

As a result, the US dollar is classified as a ‘safe haven’ currency. In other words, when everyone is frightened and worried, then the US dollar is seen as a ‘safe’ place to put your money, and as a result investors and speculators will run for cover to the US bond market. Money flow and risk go hand in hand and work on the fulcrum of fear and greed, or risk and return, if you like. If you are greedy and prepared to take on more risk, then you are rewarded with higher returns. If you are frightened and want a lower risk investment, then the returns will be lower.

The US dollar is therefore the ultimate barometer of risk. It is the fulcrum on which the currency markets balance, and indeed in many ways, all you need to do to succeed as a forex trader, is to have a clear view of the US dollar. If the US dollar is going up, then other currencies will be going down, and vice versa. It really is that simple.

The importance of the US dollar is further reinforced with one chart that reveals strength and weakness against several of the major currencies (which we’re going to look at next), and that’s called the US dollar index.

This is one of the single most important charts to watch, whatever the time frame you are trading, or whether you are an investor, or a pure speculator. This one chart will tell you whether the US dollar is rising or falling against those currencies around the world which are quoted against the dollar.

The dollar index is the starting point for every forex trader, every day, and should be yours too. Understand where the US dollar is in relation to the other major currencies, and you then have a ‘framework’ against which to trade. The US dollar sets the landscape for the forex market, and the US dollar index chart displays this for you quickly and easily.

There are several versions of the US dollar index which display US dollar strength and weakness, using a different ‘basket’ of currencies. The oldest of these is the USDX, which was originally introduced in 1973, following the collapse of the gold standard, and has been the ‘industry standard’ ever since. The US dollar is measured against six other currencies which are all weighted. The euro has the greatest weighting at almost 58%, with the Japanese yen next at almost 14%, with the British pound, Canadian dollar, Swedish Krona and Swiss franc making up the remainder.

Whilst this index has been widely used, and is freely available on the internet, in my humble opinion, it has several fundamental flaws.

First, the weighting of the currencies is very heavily skewed to Europe, with the euro and the pound accounting for over 70%. Not only is this not very representative, it no longer represents the ‘real world’. In the 1970’s this may have been the case with the index changing in the late 1990’s as the euro was launched. However, in today’s world, the currency landscape has changed dramatically, and the euro may even disappear in the longer term should the European project ultimately fail.

Second, the weighting for currencies such as the Japanese yen no longer represent the importance of this major currency.

Third, the Australian dollar does not even appear in this basket of currencies. As one of the strongest commodity currencies, it is odd to think an index for the US dollar has no representation of the commodity markets, given commodities are priced in US dollars and therefore have a strong correlation with this sector.

Nevertheless, this index remains very popular, and below is an example from the Investing.com site which you can find by clicking on the link.

This is shown in Fig 2.10.

However, I believe there is a better and more representative dollar index, which has only recently been launched, and this was a joint venture between FXCM, one of the world’s largest FX brokers, and the Dow Jones organization.

This index takes a very simple approach and uses four currencies, the euro, the British pound, the Japanese yen and the Australian dollar, and gives them an equal weighting, so that each has a 25% weighting against the US dollar. Below is an example using the daily chart again. The symbol for this index is USDOLLAR and you can find further details on this index here:

http://www.djindexes.com/fxcm/

It is widely available free in both Yahoo finance and also Google finance, so you do not need any special trading account. The example here is from my NinjaTrader trading account.

The scale of both charts is different, with the ‘original’ USD index typically moving between 70 to the downside and 100 to the upside, whilst the DJ FXCM index is based on a mini lot of 10,000. The underlying principle however is the same. To show US dollar strength or weakness against the other currencies in the market. It is just two different ways of presenting the same thing. My personal belief is the DJ FXCM is more truly representative of the currency market, and whilst simpler to understand, is more realistic in it’s presentation of the US dollar and the underlying relationships in the market.

The euro is the single currency of most of Europe, although not all, and was introduced initially to the financial system in 1999, with coins and notes in circulation from 2002. It was introduced by the politicians, superficially to create a ‘unified’ Europe, which in theory would be capable of challenging the major industrial powers of the US and China in world trade. This was how it was proposed to the European public. History of course tells a very different story, with monetary unions of this kind, always ultimately failing, since there can be no monetary union, without political union, and for Europe, this will never happen. Longer term, history suggests the euro is doomed.

Since the crisis of 2007, the euro has staggered and lurched from one crisis to another, but as the years have gone by, the markets have become increasingly inured to the weekly diet of crisis and recovery. The PIGS were first, with Portugal, Ireland, Greece and Spain all threatening to default, with the prospect of being forced out of the ‘euro project’. The most recent casualty has been Cyprus, with banks forced to close to prevent a run on capital reserves.

The euro has only survived thanks to support from the ECB, which now stands as the lender of last resort, coupled with support from Germany, the single most powerful economy in Europe. Without these twin pillars the euro would collapse, with the most revealing comment coming from Mario Draghi, the President of the European Central Bank who in 2012, said:

These are not the words of someone who is about to see the euro project fail, which is why I said at the start the euro is a political currency in every sense of the word. The politicians in Brussels and the ECB, the central bank, simply will not, and cannot allow the euro to fail. There are too many egos at stake, and too many politicians have staked their futures on it. Failure is not an option. At least, not just yet. But how does this impact the euro and its price characteristics?

First, given all the problems to date, it is seen as a high risk currency, and the opposite of the US dollar in this respect.

Second, it is heavily influenced by political rhetoric of every kind, from the central bank to politicians, and can therefore behave in some very strange ways. As a forex trader we always have to remember the statements made by politicians and from the ECB are made with one simple objective in mind - to keep the euro afloat.

Third, and somewhat ironically given the above checkered history, it is the second most widely held currency by banks around the world. The euro is constantly touted as a possible replacement to the US dollar as the currency of first reserve, generally by those dissatisfied with the current US economic policy of sustaining an artificially weak currency. The euro is the largest constituent of the basket of currencies against which the US dollar is quoted for the dollar index, at almost 58% which is odd when you think about it. And remember in chapter one, the dominance of the yen during the Asian trading session, with the euro almost nowhere to be seen. Which is one of many reasons why I have a problem with the ‘old style’ dollar index. I just don’t think it is representative of true market conditions any longer.

The Japanese yen is a currency heavily influenced by several factors, some overt and some covert, which make it one of the most volatile and difficult currencies to trade. It has a characteristic and personality all of its own, and is very different to the first two currencies we have considered here. The reasons for this can be traced back to the financial crisis that engulfed Japan and its economy in the late 1980’s, once again one that was caused and created by an economic bubble based on cheap credit. The bubble finally burst in 1990, with the subsequent collapse of several banks, housing repossessions and an economy that hit the buffers overnight.

At the time, the Japanese were still regarded as an economic miracle, having recovered from the Second World War to transform themselves into one of the leading exporting nations in the world. The central bank, the Bank of Japan was forced to act, and with the country mired in recession, had no choice but to reduce interest rates to zero and just above, in an attempt to stimulate growth in the country. This has remained a feature of Japan and its economy ever since, with interest rates remaining at these ultra low levels. In addition, as a major exporter and the third largest in the world (only recently surpassed by China), Japan’s central bank has always taken a protectionist stance to ensure the currency remains weak, in order to protect the lifeblood of the country - its export market.

As a result of the above, the Japanese yen has several interesting characteristics.

First, just like the US dollar, it is considered by the market to be a safe haven currency. When investors and speculators are fearful, the Japanese yen is bought, and equally when these groups are happy to take on more risk, the yen is sold. And the reason for this is what is known as the carry trade. In simple terms this is a strategy that takes advantage of the differential interest rates between two currencies, one with a low interest rate and the other with a high interest rate.

Owing to its economic history, the Japanese yen duly became the ‘de facto’ standard for the low yielding currency, and therefore sold when investors and speculators were in search of higher yielding currencies. Equally, when markets were fearful, the Japanese yen would be bought and the high yielding currency sold, resulting in the consequent ebb and flow of buying and selling in the yen as risk appetite reversed. As a result, the yen is seen as a safe haven currency.

Second, as I mentioned earlier, the Bank of Japan is one of the most interventionist in the world, and will step into the currency markets at any time, should it feel its export markets are under threat from a strong yen. Whilst the BOJ is independent from the government, it is nevertheless, heavily influenced by them, and both parties have only one objective - to protect their export markets at all costs.

Third, the Japanese have some curious exporting traditions in terms of their currency, and unlike every other major exporter around the world, their goods are invoiced in the currency of the import nation. For example, when the USA is importing cars from Japan, the invoice will be in US dollars and paid for in US dollars, and not Japanese yen. This net inflow of foreign currency reserves then has to be converted back to yen, selling US dollars and buying yen. The Japanese are creatures of habit and this is generally done for accounting purposes at the end of September and the end of March, resulting in some curious, but predictable behavior in the currency.

Finally, Japan is heavily dependent on imports of commodities as it has few natural resources of its own, so currency movements in the yen are often influenced by, and reflected in, certain commodities such as oil.

The British pound, or Sterling, as it sometimes referred to, is the black sheep of Europe. The British government was wise enough to retain its home currency, and despite protestations from many in Europe, remains on the inside politically, and on the outside monetarily, which upsets many in Europe as you might expect. But not for much longer following the Brexit decision, and which has since led to extreme volatility in all pairs as negotiations ebb and flow. Once a deal has been agreed, no doubt volatility in the British pound will die away and price action return to more normal patterns of behaviour.

Under normal conditions, the pound can best be characterized as steady. It is not normally volatile (other than during Brexit), has no particularly strong influences, and in many ways reflects the British personality - measured and controlled with occasional bouts of excitement. It is rather like Big Ben - old father time, safe and dependable, and for new currency traders is a great place to start. Unlike the Euro, it has no political influences, is managed by the Bank of England, and with London still considered as the financial centre of the world, is therefore viewed as ‘safe’. Of all the currencies, it is the pound which perhaps has been the least affected by the financial crisis of the last few years. That said, please be aware of Brexit, as news, statements and comments, can and do have an instant impact across the currency complex for the pound, with prices plunging or rising quickly in minutes, only to reverse thereafter.

Whilst the UK central bank, the Bank of England followed the US authorities with their own brand of quantitative easing, the extent and depth has been modest in comparison. As a result, the pound has retained a modicum of ‘predictability’ sadly lacking in many other currencies. The pound is also relatively free from political influences, and therefore reacts to fundamental news, in a more predictable way - that word again. If the data is good for the pound, it is likely to be reflected in the currency which should strengthen. Conversely, bad news should see the pound weaken. In these uncertain times, the pound is certainly one currency that tends to more truly reflect the underlying fundamental picture, than many of its neighbors.

The first of these is Australia, a country rich in natural resources, and whose export markets depend on demand for basic commodities, such as iron ore, coal and of course gold. Mining lies at the heart of the economy. Iron ore and gold account for almost 30% of exports, with coal accounting for a further 18%, and it probably comes as no surprise the Australian dollar has a strong relationship with the price of gold. When gold falls in price, the Australian dollar tends to fall along with it, and rise when the price of gold is rising, so a direct and positive relationship.

Being dependent on commodity exports, and with China as its largest trading partner, the Australian dollar is particularly sensitive to any economic data from this country. The Australian economy has weathered the financial storm of the last few years better than most, with interest rates remaining higher (relatively speaking) throughout, and as a result, the currency has been one of those favored as the high yielding currency in the carry trade. In addition, and slightly at odds with this statement, the currency has also been seen increasingly as another ‘safe haven’ due to the way the economy has been managed through the crisis, and not just survived, but prospered as well.

Just like the Australian dollar, the Canadian dollar, often referred to as the Loonie, is the second of our commodity based currencies, but this time the commodity in question is black gold, or oil. To put this into context, which is often a surprise to many forex traders, Canada has the third largest oil reserves of any country in the world after Saudi Arabia and Venezuela. The most significant deposits are those in the Alberta Sands in Northern Alberta, dwarfing those of more traditional oil producers in the Gulf states.

Whilst this is good news for Canada and its commodities driven export market, what is less good news is over 80% of exports are absorbed by its nearest neighbor, the USA. As the saying goes, when the US economy sneezes, Canada catches a cold. Nevertheless, despite this, Canada, just like Australia, is another country that has weathered the financial storm well, and escaped relatively unscathed.

As you would expect with a country dominated by commodities and oil, the Canadian dollar has a close relationship with the oil market, and any fall in the price of oil is likely to be reflected in the currency which may weaken as a result. Conversely, if the price of oil is rising, the Canadian dollar is likely to strengthen along with it. Any economic data relating to oil will also affect the currency, and the one we watch here are the weekly oil statistics, which report whether oil inventories have been increasing or decreasing. In other words, a snapshot of the supply and demand relationship for crude oil.

Whilst New Zealand is also rich in natural base commodities, it is soft commodities which dominate its export markets, with milk powder, butter and cheese the main constituents.

However, there is one aspect of New Zealand’s economy which dictates the behavior of the currency in the markets, and that’s interest rates. Prior to the start of the financial crisis, interest rates were 8.25 %, making the currency the number one target for the carry trade, causing two major problems for the central bank. First, a strong currency, which undermined the export market, and secondly an extremely volatile currency, caused by the constant speculation, a feature of all high yielding currencies on this side of the carry trade. Since 2009, interest rates have fallen and are currently at 1.75%, with a consequent drop in the use of this currency for this strategy, sending currency speculators hunting for higher yields elsewhere. Nevertheless, once the current crisis is over, the New Zealand dollar will return to this once traditional role, as soon as interest rates begin to rise again.

The Swiss franc can be summed up in one word. Safety. Switzerland is seen as a safe country, with a safe and secure banking system, underpinned by massive gold reserves. It is a country with an extremely high standard of living and is outside the EU, yet geographically in Europe. It also has a central bank which makes no effort to conceal any intervention into the currency markets, and just like the Bank of Japan, does this frequently and often as the need arises.

This has certainly been the case in the last few years with the Swiss franc increasingly seen as safe haven in these troubled times, forcing the central bank to step in on several occasions, all of which failed to prevent further buying of the currency.

The currency is also heavily influenced by the price of gold. Firstly, because gold itself is seen as a safe haven asset in its own right, but also because the Swiss banking system is underpinned by the world’s fifth largest holding of the precious metal at just over 1100 tonnes. The gold is held in reserves to ensure the stability of the Swiss franc, with the currency reflecting changes in the price of gold as a result.

These then are the primary currencies we are going to focus on in the remainder of this book. There are, of course, many other currencies around the world, sometimes referred to as exotic currencies. There is nothing wrong with trading these once you have some experience. However, whilst exotic currencies can offer better and faster returns, they are not without their problems, and volatility and lack of liquidity being just two. I have written other books where I explain these currencies and the opportunities, but this book is intended as a guide for new traders, and therefore the currencies I have outlined above are those that are considered to be both widely traded, and relatively cheap to trade.