What Everyone Must Know About Currencies: Profiting From Risk Rankings

by: Cliff Wachtel

Understanding currency risk rankings & how to profit from them - even if you're not a forex trader

Part 2 of our series on inter-market analysis. How the major currencies and pairs respond to market sentiment, why all types of traders or investors need to know it, and how anyone can use it for safer and higher returns. Enjoy.

As noted in our introduction to inter-market analysis, most assets behave as either risk or safety (aka safe haven) assets. So do the major currencies. Some are risk currencies, because they tend to move in the same direction as other risk assets like stocks or industrial commodities, rising in times of optimism (aka risk appetite or 'risk on' periods) and falling in when sentiment turns pessimistic (aka 'risk off' periods). Others currencies are considered safety currencies because they behave in the opposite manner, behaving like AAA rated bonds, appreciating on increased demand in times of fear and falling in times of optimism as market participants sell them and move into risk currencies or other risk assets.

The Currency Risk Ranking

Here's how the major currencies generally rank, with those that usually behave most like risk assets on the left, and the lowest ranking risk currencies (or highest ranking safe haven currencies) on the right.

(Click to enlarge)

Source: The Sensible Guide To Forex: Safer, Smarter Ways to Survive and Prosper from the Start, Cliff Wachtel, John Wiley & Sons, 2012

For example, in times of optimism when risk assets as a group are moving sharply higher, we would expect the AUD to be doing best, followed by the NZD, CAD, and so on, with the JPY, USD, CHF, and so on depreciating the most. In times of fear, when risk assets are falling, we'd expect the currencies on the opposite, safety end of the risk spectrum to appreciate most and those on the risk end to fall the most.

Currencies trade in pairs, and pairs move up or down depending on whether the base currency (the one on the left) is moving up or down relative to the counter currency (the one on the right).

So in times of optimism (aka risk appetite) we'd expect the best pairs to buy (go long on) are those with both an extreme risk base currency (AUD, NZD, CAD, etc.), and an extreme safe haven counter currency (JPY, USD, CHF, etc.), like the AUDJPY, AUDUSD, NZDJPY, NZDUSD, EURUSD, and so on.

Similarly, in times of fear, traders we'd expect the opposite performance. Risk pairs like those just mentioned are shorted, or traders go long on pairs with a relatively safe base currency versus its counter currency, like the USDCAD, GBPAUD, and so on. Details follow below.

Why This Ranking Is So Useful: You Can Analyze, Hedge, And Profit Better

Knowing which pairs go up or down relative to other asset classes can be extremely useful in a number of ways.

1. Forex markets often signal market changes ahead of other markets: For example, as discussed in Part 1 of this series, if you're a stock investor, and if you see that stocks are rising, but the main risk pairs and currencies are falling. then you've got an important inter-market divergence that you need to investigate to see if currencies are sending you an advanced warning of a coming stock market reversal.

2. You can always hedge or profit in a risk-averse market: This is a big deal. When markets get scared, the trends can be especially steep and fast. Risk assets dive, safety assets soar. These kinds of markets provide some of the very best trading profit opportunities if you can ride the trend early enough. However that can be hard to do if you're trading/investing repertoire does not include spot forex pair trading. For example stocks are notoriously problematic for shorting when you need them the most.

· The stock you want to short isn't always available.

· Worse, many of the exchanges can and will limit or halt trading in some or all stocks, or ban shorting in some or all stocks for extended periods.

· Uptick rules (you can't sell short unless the stock is rising) are removed in good times but reinstated in bad times, making shorting harder and riskier

Or, commodity exchanges also have ways to "reduce volatility in the interests of orderly markets." Margin requirements are raised, etc.

The big institutions have the skills and resources to circumvent these obstacles( and hedge or profit in these situations) that the private investor lacks. However you can always play the fear trade, as long as you can just short a risk pair like the AUDJPY, or go long a safe haven pair, like the GBPNZD, (or others) depending on which pairs provide the best risk/reward opportunities, entry points, etc.

Guess what? You can always do that.

Currencies always trade in pairs. Without getting too technical, that means you can always 'short' risk assets or play risk averse market trends with currencies even when other markets are closed to you:

· Every position every trader ever takes always involves buying one pair and selling the other. Every trade involves a long and short position. So even if there were just a few centralized forex exchanges (there aren't) it would be impossible to ban shorting one or more currencies without completely shutting down trade in them, and most related international trade involving those currencies. Not going to happen.

· As noted above, pairs comprised of currencies on the opposite ends of the risk spectrum like the NZDCHF or NZDUSD tend to be more sensitive to changes in risk appetite. In other words, the price of these pairs will tend to be especially volatile in times of strong optimism or pessimism, because both should be trending strongly, but in opposite directions. Pairs comprised of two currencies in the middle of the risk ran spectrum shown above (like the GBPCHF) should usually be less sensitive to risk sentiment (although they can still react strongly to it if the news or long term developments driving that 'risk on' or 'risk off' atmosphere are more closely related to that currency or its economy.

Therefore knowing which currency pairs rise or fall with in times of optimism or pessimism can be incredibly useful in currency markets for lowering risk and improving returns. If stocks or other risk assets are plunging you can find a risk pair to short or a safety pair to buy.

In sum, if you know how forex pairs trade, you always have a way to play extreme risk aversion trends when less savvy investors can't.

What Determines This Ranking?

This can be a complex topic. The short basic explanation for why certain currencies (and thus the pairs that they comprise) respond differently to risk appetite is this: differences in both prevailing and anticipated benchmark interest rates associated with it is the main factor in determining how a currency responds to good or bad news. Why? There are a number of reasons, but the most important one is carry trade. A currency carry trade strategy is the selling of one currency with a relatively low interest rate and using the funds to purchase another currency yielding a higher interest rate, and profiting from the rate differential. That can be huge when using leverage (borrowed funds), and use of high leverage is common in forex markets.

For example:

· A trader borrows yen at nearly 0%, converts the funds into a currency with high benchmark interest rates like the Australian dollar, and buys a bond paying 4% per year, earning 4% per year.

· For those trading in large blocks of currency (like big institutional traders) or at least controlling large blocks of currency via leverage, even the daily profit on that spread (4% * 1/365) can be considerable depending on the leverage used.

· For example if using 100% leverage, that's 400% per year, or better than 1% per day. IF (a big if, so it's important to read the trend well) the AUDJPY exchange rate doesn't move against the trader. A small change in exchange rates in the wrong direction can quickly wipe out the anticipated profit. Currency rates can change a lot faster per day than the 0.27% of your annual interest earned each day (1/365 =0.0027) on a carry trade.

As you can see, a full discussion of carry trade would be lengthy and beyond the scope of this article, as would a discussion of other fundamental drivers of currency risk rankings.

For now, suffice to say that the bigger the interest rate advantage offered by the bonds and fixed income instruments of one currency over the others, the more likely that currency will be bought in times of optimism about growth, and sold in times of pessimism. This is a simplification, but a useful one for the scope and focus of this article.

That said, two points to leave you with before proceeding.

· First, obviously the above implies that the factors which move interest rates or expectations about them will thus be the true drivers of risk ranking. True, but again, that's a whole separate topic for its own article. Stay tuned, we'll get to it at some point.

· Second, note that because interest rate spreads between currencies and their benchmark notes and bonds are so influential in determining a currency's place in the risk spectrum, obviously these risk rankings can and do change as rate spreads change.

Currency Correlations With Risk Sentiment: A Useful But Imperfect Tool

While the above risk ranking is useful for predicting how currencies should be moving at a given time, in reality currencies rarely perform exactly according to their risk ranking in strongly 'risk on' or 'risk off' periods on any given day. There are other drivers of forex trends besides risk appetite and these can and do dominate currency movements, especially in the short term.

A few examples of such influences include:

Currency specific news or longer term developments in that currency's underlying economy can also alter these relationships. For example even on strong 'risk on days or longer periods, bad economic news about the Australian economy, or its chief trading partner, China, can cause the AUD to underperform other risk currencies. Economy-specific news and other short term developments are a major reason why currencies don't perform in accordance with market sentiment in the short term.

Relative strength of a currency's primary trading counterpart can also alter how a currency should behave based on its place on the risk spectrum. Currencies trade in pairs, so changes in currency pair prices always reflect changes in relative value. In some cases changes in demand for one currency can have dramatic effects on the other that have no direct connection to changes in risk appetite. For example, as we discussed in Part 1 of this series here, the EUR and USD virtually force each other to move in opposite directions because they are the most widely traded currencies and so purchases of one are so often funded by sales of the other. Thus if one is being heavily bought the other will tend to sell off regardless of normal drivers like risk appetite.

Central bank interventions can be a classic kind of event that alters how we'd expect a currency to behave relative to risk appetite. For example, during the summer of June 2011 when EU crisis anxiety was high and investors were flooding into the CHF, the Swiss central bank intervened to keep the CHF from rising beyond a certain rate in order to keep Swiss export prices down and competitive within the EU, Switzerland's chief export market. The CHF plunged vs. the USD, EUR, and other currencies due to this intervention, not because of any big change in risk appetite.

Of course, in recent years central bank interventions (or speculation about them) have become, ahem, more than just outlier events. They are now an ever-present global market driver and are likely to remain so for years as until economies are healthy enough to prosper without them.

Central Bank Interventions As Primary Risk Sentiment Drivers

It's no secret that central bank interventions have in fact BEEN a primary (if not THE primary) market sentiment driver. It certainly wasn't improvements in the normal economic fundamentals that have driven most global stock markets in the developed world up near historic highs for most of 2013. Indeed we've had slow to flat growth or worse in employment, wages, and earnings.

Not only has the rally in stocks to historic highs lacked fundamental support, it has occurred under an exceptional number of recessionary threats. For example:

· The slowdown in the world's one big growth engine, China

· The dormant but very much alive and unsolved EU debt and banking crisis

· Japan's experiment with radical easing despite it's already highest in the developed world debt/GDP and lack of any clear way to reduce it as its workforce and trade balance continue to shrink

The point is, in the current environment; don't forget that central bank interventions have not been outlier events, but rather primary drivers of currency trends, both via their effects on interest rates and overall risk sentiment.

Seek The Underlying Drivers of Risk Appetite

That brings us to our concluding point.

While it's very useful to know how to monitor risk appetite, (as we discuss in Part 3 of this series), and how to use currency pairs as another tool for hedging or profiting in times of changing risk sentiment, don't forget what risk sentiment really is and where it comes from.

Remember that that risk sentiment doesn't just create itself, it is usually just a shorthand description of the net effect of one or more underlying fundamental market drivers, regardless of whether we can accurately identify all of them.

Attempting to read risk sentiment and how currencies (or whatever your asset of choice) will react is useful, but it's not a substitute for real fundamental analysis of what's driving markets in your given time frame.

DISCLAIMER: The above is for informational purposes only and not intended to be specific trading advice. In other words if somehow you lose money based on the above I take no moral or legal responsibility for it. Deal with it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.