FINDING THE FOREX BULL MARKET IN THE EU CRISIS: PART 1
Most Markets May Plunge When EU Anxiety Is High-But In Forex There's Always A Bull Market Somewhere
Here In Part 1 We Cover Key Background Information: The Distinction Between Risk & Safe Haven Currencies
Any prudent investor now needs a basic grasp of foreign exchange (forex) markets. Economic policies are eroding the value of most major currencies and anything denominated in them. The following is an excerpt from The Sensible Guide To Forex: Safer, Smarter Ways to Prosper from the Start. In this excerpt we cover some forex basics that all investors can use right away to improve their returns, even if they never trade forex.
While it sounds strange to think that there could be any winners from the ongoing deterioration and possible end of the EU and EUR as we know it, in forex there are always winning and losing currencies, because currencies always trade in pairs, with one always rising and one always falling versus the other. In forex, unlike other asset markets, there's always a bull market somewhere.
Even better, you don't have to be an active trader to exploit these markets. As we showed in Forex markets produce some of the most stable long term trends that are perfect for passive long term investors. The basic reason why forex produces more and better long term trends than other markets like stocks is:
Currencies endure far longer than the average publicly traded company
While the fundamentals of a company can change within a matter of months, fundamentals of national economies change much more slowly. The relative competitiveness of an entire nation or economy, its growth and employment rates, etc, can take years or decades to change. Currencies tend to behave like the shares in an economy, so if one economy is doing better than another, that situation tends to persist for years or even decades. While long term market trends that favor risk or safety currencies can influence the trend of a currency pair, secular bull or bear markets also take years to play out, and so long term expansion and contraction cycles can also reinforce certain long term forex trends.
The most basic criteria to understand about each of the major currencies is
- whether they are risk or safe-haven currencies
- how that determines their performance and correlation to other types of assets
- how to profitably exploit that knowledge
The following article is a summary from the book's more detailed coverage of this topic, and provides the needed background information to understand Part 2 of this series.
Definition of Risk vs. Safe Haven (Or Safety) Currencies
Here's the basic distinction between risk and safe haven currencies.
- Risk currencies behave like other risk assets, such as stocks or industrial commodities (oil, gas, copper, etc); they rise when markets are feeling optimistic, and fall when markets are nervous.
- Safe haven or safety currencies behave in the opposite manner, like other safe haven assets (investment grade bonds and commercial paper, short term money market funds, etc), rising in times of fear and falling in times of optimism about economic growth.
NB: These classifications have NOTHING to do with how safe a given currency may be as a store of value. Rather these names refer ONLY to whether the currency generally behaves like other risk or safe haven assets.
For example, although the CAD is considered a "risk" currency, Canada's low debt/GDP, strong economy and healthy banking system makes it one of the safest currencies as a long term store of value in which to have your savings.
The Risk Ranking
Here's the traditional ranking of currencies in order of risk, that is, which ones benefit most when markets are feeling optimistic, going from left to right:
This means that when risk assets are rising (aka a "risk on" market), traders typically are:
- Long pairs that have a base currency that is higher on the risk scale than their quote currency, like the AUDJPY or EURUSD
- Short pairs that have a base currency that is lower on the risk scale than their quote currency, like the GBPAUD or EURNZD
When risk assets are falling (aka a "risk off" market), traders typically do the opposite. Remember, currency pairs move in the direction of the base currency, rising when it rises relative to the quote currency, and vice versa.
The ranking rarely works perfectly over a matter of days or weeks but is a useful generalization that works in the longer term.
Currency-specific news items regularly cause currencies to behave out of order from this ranking in the short term. For example:
- Even if markets are feeling very pessimistic, if there is news that is bad for the JPY, it may not be strong that day despite the market being in "safe haven" mode.
- Even in times of optimism, the AUD could underperform the other risk currencies due to specific events or conditions influencing:
- Australia, like slowing growth or sinking expectations about interest rate increases.
- Bad news about the economy of its biggest export customer, China
In descending order these are: the JPY, USD, and CHF. Thus when markets are nervous, the JPY is usually the strongest, followed by the USD and CHF, and all 3 of these to gain against the above risk currencies. During times of great pessimism, most traders would try to short the following pairs by buying puts on them: AUDJPY, AUDCHF, AUDUSD, NZDJPY, NZDCHF, NZDUSD, etc.
Again this ranking is a generalization.
Currency specific events can cause currencies to perform in ways contrary to their risk or safety ranking. For example, over the past years the CHF has in fact been the preferred safe haven due to Switzerland's stronger economy and lower debt levels relative to those of the US and Japan. However when there is great fear about Europe's economy, the CHF may weaken, because most of Swiss exports would suffer. Also, the Swiss National Bank, like other central banks, periodically intervenes to keep the CHF low in order to protect Swiss exports.What Causes A Currency To Become A Risk Or Safety Currency?
While there are other factors that we cover in the book, here's a quick look at the most important ones.Benchmark Central Bank Short Term Interest Rates
There are a number of factors, the strongest of which is the currency's benchmark short term yield. Those currencies with higher short term interest rates, or those expected to have higher rates in the future, tend to move with risk assets due to their use in carry trade (buying of higher yield currencies funded by selling of lower yielders and profiting on the difference in rates while you hold the long and short positions).Expectations About Future Rates
Closely related to the above are market expectations about whether a given currency's yield will be rising, falling, or flat in coming months. While interest rate differentials may determine longer term risk ranking, its expectations about those differentials that can determine how performs against another over a given period. For example, let's say that 2 central banks A and B both announce a 0.25% rate increase on the same day. If the rate hike for A is believed to be the last one, and the hike for B is believed to be one of more increases still to come, then A is likely to sell off on profit taking. Meanwhile B is likely to enter a sustained uptrend, certainly against A, as traders see the increase as confirmation of the anticipated chain of coming rate increases.
Thus if interest rates for a given currency are expected to rise dramatically relative to those of other currencies (typically due to rising growth expectations for that nation) it's possible for a formerly low yielding safe haven currency to evolve into a high yielding risk currency. The opposite can also happen.There Are Other Determinants of Currency Risk Ranking
While current and expected future yields are crucial, they're not the only determinants of risk ranking. For example, currencies of export based economies that prosper or decline with global growth logically behave like other risk assets and hence are considered risk currencies. For example in recent years the yield on the CAD was equal and often lower than that of the EUR, yet the CAD was overall higher on the risk spectrum than the EUR.
Now that you've got the above background information on risk and safe haven currencies, we can move on to Part 2 -their correlations and how to use them, that's already up. After that, you're ready for Part 3- finding the profit opportunities in forex markets from the EU crisis. It should be up within the coming week.
While forex markets are typically associated with high risk, complex, time consuming short term trading, there are many safer, simpler ways that conservative investors or traders with limited time and skills can tap forex markets for currency diversification and currency diversified income. To learn more about how to improve your returns through conservative forex trading and investing, take a look at The Sensible Guide To Forex: Safer, Smarter Ways to Prosper from the Start.
It's the only book specifically written to show mainstream investors how to survive and hedge currency risk posed by unprecedented money printing by most major central banks, and how to prosper by safer, simpler ways to exploit forex and commodity markets, either as conservative traders or income investors, for lower currency risk and better returns. It's essential reading for all investors, because a good investment in a bad currency is a bad investment. Click here for a description of the book, and here for advanced reviews. It's due out in September 2012, reserve your copy by clicking here.
Disclosure: For informational purposes only. No positions.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.