FUNDAMENTAL TRADING STRATEGIES
PICKING THE STRONGEST PAIRING
When trading currencies, many traders make the mistake of shaping opinions around only one specific currency without taking into account the relative strength and weakness of both of the currencies in the pair that they are trading. In the FX market, this neglect of foreign economic conditions has the potential to greatly hinder the profitability of a trade . It also increases the odds of a loss. When trading against a strong economy, there is more room for failure; the currency you want to trade could flop badly, leaving you stuck against a currency more likely to appreciate. Likewise, there is an augmented chance that the other currency could strengthen, resulting in a trade with negligible gains. Therefore, finding strong economy/weak economy pairings is a good strategy to use when attempting to maximize returns.
Take for example March 22, 2005—the U.S. Federal Reserve upped its risk for inflation in its Federal Open Market Committee (FOMC) statement, causing every major currency pair to tank against the dollar. Along with this, a slew of positive U.S. economic data further reinforced the dollar’s strength. While you probably could have gained on any long dollar trade at that point, in some of the pairs the dollar appreciation had much more staying power than in others. For example, after the initial bloodbath, the pound did show a rebound in the weeks after the Fed’s meeting,while the yen depreciated for a longer period of time. The reason is because at the time, Britain’s economy had been exhibiting a consistent, impressive amount of economic growth, which, after the compulsive dollar frenzy, helped it gain back some substantial ground within a matter of a few weeks. The rebound in the British pound against the dollar can be seen. After hitting a low of 1.8595 on March 28, the pair proceeded to rebound back toward its pre-FOMC level of 1.9200 over the next three weeks.
On the other hand, the Japanese yen saw a depreciation over a much longer period of time with a continual upward movement in the USD/JPY pair well into the middle of April. After the FOMC meeting, the dollar proceeded to strengthen another 300 pips over the next two weeks. Part of the reason for the differences in these movements was that market watchers did not have much faith in the Japanese economy, which had been teetering on the edge of recession and showing no signs of positive economic expansion. Therefore, the dollar strength had a much higher impact and an increased amount of staying power with the struggling yen than with the consistently strong pound.
Of course, interest rates as well as other geopolitical macro events are also important, but when weighing two equally compelling trades, finding the best strong economy and weak economy pairing can lead to higher chances of success. Examining crosses of the majors during this time period shows another way that knowledge of the strength of different currency pairings can be used to increase profitability. Following the FOMC meeting on
FIGURE GBP/USD Post Fed Meeting
FIGURE AUD/JPY Post Fed Meeting
FIGURE EUR/JPY Post Fed Meeting
March 22, both AUD/JPY and EUR/JPY sold off, but AUD/JPY rebounded much quicker than EUR/JPY. One of the reasons why this might have occurred could very well be the strong economy/weak economy comparison. The Eurozone economy experienced very weak growth in 2003, 2004, and into 2005. Australia, on the other hand, performed much better and throughout 2004 and the first half of 2005 Australia offered one of the highest interest rates of the industrialized world. As a result, as indicated in Figure, the currency pair rebounded much quicker than EUR/JPY post FOMC. This is why when looking for a trade, it is important to keep strong economy/weak economy pairings in mind.
LEVERAGED CARRY TRADE
The leveraged carry trade strategy is one of the favorite trading strategies of global macro hedge funds and investment banks. It is the quintessential global macro trade. In a nutshell, the carry trade strategy entails going long or buying a high-yielding currency and selling or shorting a low-yielding currency. Aggressive speculators will leave the exchange rate exposure unhedged, which means that the speculator is betting that the high-yielding currency is going to appreciate in addition to earning the interest rate differential between the two currencies. For those who hedge the exchange rate exposure, although interest rate differentials tend to be rather small, on the scale of 1 to 5 percent, if traders factor in 5 to 10 times leverage, the profits from interest rates alone can be substantial. Just think about it: A 2.5 percent interest rate differential becomes 25 percent on 10 times leverage. Leverage can also be very risky if not managed properly because it can exacerbate losses. Capital appreciation generally occurs when a number of traders see this same opportunity and also pile into the trade, which ends up rallying the currency pair.
In foreign exchange trading, the carry trade is an easy way to take advantage of this basic economic principle that money is constantly flowing in and out of different markets, driven by the economic law of supply and demand: markets that offer the highest returns on investment will in general attract the most capital. Countries are no different—in the world of international capital flows, nations that offer the highest interest rates will generally attract the most investment and create the most demand for their currencies. A very popular trading strategy, the carry trade is simple to master. If done correctly, it can earn a high return without an investor taking on a lot of risk. However, carry trades do come with some risk. The chances of loss are great if you do not understand how, why, and when carry trades work best.
How Do Carry Trades Work?
The way a carry trade works is to buy a currency that offers a high interest rate while selling a currency that offers a low interest rate. Carry trades are profitable because an investor is able to earn the difference in interest—or spread—between the two currencies.
An example: Assume that the Australian dollar offers an interest rate of 4.75 percent, while the Swiss franc offers an interest rate of 0.25 percent. To execute the carry trade, an investor buys the Australian dollar and sells the Swiss franc. In doing so, he or she can earn a profit of 4.50 percent (4.75 percent in interest earned minus 0.25 percent in interest paid), as long as the exchange rate between Australian dollars and Swiss francs does not change. This return is based on zero leverage. Five times leverage equals a 22.5 percent return on just the interest rate differential. To illustrate, take a look at the following example and Figure to see how an investor would actually execute the carry trade:
Executing the Carry Trade
Buy AUD and sell CHF (long AUD/CHF).
Long AUD position: investor earns 4.75 percent.
Short CHF position: investor pays 0.25 percent.
With spot rate held constant, profit is 4.50 percent, or 450 basis points.
FIGURE Leveraged Carry Trade Example
If the currency pair also increased in value due to other traders identifying this opportunity, the carry trader would earn not only yield but also capital appreciation.
To summarize: A carry trade works by buying a currency that offers a high interest rate while selling a currency that offers a low interest rate.
Why Do Carry Trades Work?
Carry trades work because of the constant movement of capital into and out of countries. Interest rates are a big reason why some countries attract a great deal of investment as opposed to others. If a country’s economy is doing well (high growth, high productivity, low unemployment, rising incomes, etc.), it will be able to offer those who invest in the country a higher return on investment. Another way to make this point is to say that countries with better growth prospects can afford to pay a higher rate of interest on the money that is invested in them.
Investors prefer to earn higher interest rates, so investors who are interested in maximizing their profits will naturally look for investments that offer them the highest rate of return. When making a decision to invest in a particular currency, an investor is more likely to choose the one that offers the highest rate of return, or interest rate. If several investors make this exact same decision, the country will experience an inflow of capital from those seeking to earn a high rate of return.
What about countries that are not doing well economically? Countries that have low growth and low productivity will not be able to offer investors a high rate of return on investment. In fact, there are some countries that have such weak economies that they are unable to offer any return on investment, meaning that interest rates are zero or very close to it.
This difference between countries that offer high interest rates versus countries that offer low interest rates is what makes carry trades possible.
Let’s take another look at the previous carry trade example, but in a slightly more detailed way:
Imagine an investor in Switzerland who is earning an interest rate of 0.25 percent per year on her bank deposit of Swiss francs. At the same time, a bank in Australia is offering 4.75 percent per year on a deposit of Australian dollars. Seeing that interest rates are much higher with the Australian bank, this investor would like to find a way to earn this higher rate of interest on her money.
Now imagine that the investor could somehow trade her deposit of Swiss francs paying 0.25 percent for a deposit of Australian dollars paying 4.75 percent. What she has effectively done is to sell her Swiss franc deposit and buy an Australian dollar deposit. After this transaction she now owns an Australian dollar deposit that pays her 4.75 percent in interest per year, 4.50 percent more than she was earning with her Swiss franc deposit.
In essence, this investor has just done a carry trade by “buying” an Australian dollar deposit, and “selling” a Swiss franc deposit.
The net effect of millions of people doing this transaction is that capital flows out of Switzerland and into Australia as investors take their Swiss francs and trade them in for Australian dollars. Australia is able to attract more capital because of the higher rates it offers. This inflow of capital increases the value of the currency.
To summarize: Carry trades are made possible by the differences in interest rates between countries. Because they prefer to earn higher interest rates, investors will look to buy and hold high-interest-rate-paying currencies.
When Do Carry Trades Work Best?
Carry trades work better during certain times than others. In fact, carry trades are the most profitable when investors as a group have a very specific attitude toward risk.
FIGURE Effects of a Carry Trade: AUD/CHF Carry Trade Example 1
How Much Risk Are You Willing to Take? People’s moods tend to change over time—sometimes they may feel more daring and willing to take chances, while other times they may be more timid and prone to being conservative. Investors, as a group, are no different. Sometimes they are willing to make investments that involve a good amount of risk, while other times they are more fearful of losses and look to invest in safer assets.
In financial jargon, when investors as a whole are willing to take on risk, we say that they have low risk aversion or, in other words, are in riskseeking mode. In contrast, when investors are drawn to more conservative investments and are less willing to take on risk, we say that they have high risk aversion.
Carry trades are the most profitable when investors have low risk aversion. This statement makes sense when you consider what a carry trade involves. To recap, a carry trade involves buying a currency that pays a high interest rate while selling a currency that pays a low interest rate. In buying the high-interest-rate currency, the investor is taking a risk—there is a good deal of uncertainty around whether the economy of the country will continue to perform well and be able to pay high interest rates. Indeed, there is a clear chance that something might happen to prevent the country from paying this high interest rate. Ultimately, the investor must be willing to take this chance.
If investors as a whole were not willing to take on this risk, then capital would never move from one country to another, and the carry trade opportunity would not exist. Therefore, in order to work, carry trades require that investors as a group have low risk aversion, or are willing to take the risk of investing in the higher-interest-rate currency.
To summarize: Carry trades have the most profit potential during times when investors are willing to take the risk of investing in highinterest-paying currencies.
When Will Carry Trades Not Work?
So far we have shown that a carry trade will work best when investors have low risk aversion. What happens when investors have high risk aversion?
Carry trades are the least profitable when investors have high risk aversion. When investors have high risk aversion, they are less willing as a group to take chances with their investments. Therefore, they would be less willing to invest in riskier currencies that offer higher interest rates. Instead, when investors have high risk aversion they would actually prefer to put their money in “safe haven” currencies that pay lower interest rates. This would be equivalent to doing the exact opposite of a carry trade—in other words, investors are buying the currency with the low interest rate and selling the currency with the high interest rate.
Going back to our earlier example, assume the investor suddenly feels uncomfortable holding a foreign currency, the Australian dollar. Now, instead of looking for the higher interest rate, she is more interested in keeping her investment safe. As a result, she swaps her Australian dollars for more familiar Swiss francs.
The net effect of millions of people doing this transaction is that capital flows out of Australia and into Switzerland as investors take their Australian dollars and trade them in for Swiss francs. Because of this high investor risk aversion, Switzerland attracts more capital due to the safety its currency offers despite the lower interest rates. This inflow of capital increases the value of the Swiss franc.
To summarize: Carry trades will be the least profitable during times when investors are unwilling to take the risk of investing in high-interestpaying currencies.
Importance of Risk Aversion
Carry trades will generally be profitable when investors have low risk aversion, and unprofitable when investors have high risk aversion. Therefore, before placing a carry trade it is critical to be aware of the risk environment—whether investors as a whole have high or low risk aversion—and when it changes.
Increasing risk aversion is generally beneficial for low-interestrate-paying currencies: Sometimes the mood of investors will change rapidly—investors’ willingness to make risky trades can change dramatically from one moment to the next. Often these large shifts are caused by significant global events. When investor risk aversion does rise quickly, the result is generally a large capital inflow into low-interest-rate-paying “safe haven” currencies.
For example, in the summer of 1998 the Japanese yen appreciated against the dollar by over 20 percent in the span of two months, due mainly to the Russian debt crisis and Long-Term Capital Management hedge fund bailout. Similarly, just after the September 11, 2001, terrorist attacks the Swiss franc rose by more than 7 percent against the dollar over a 10-day period.
FIGURE Effects of a Carry Trade When Investors Have High Risk Aversion: AUD/CHF Carry Trade Example 2
These sharp movements in currency values often occur when risk aversion quickly changes from low to high. As a result, when risk aversion shifts in this way, a carry trade can just as quickly turn from being profitable to unprofitable. Conversely, as investor risk aversion goes from high to low, carry trades become more profitable.
How do you know if investors as a whole have high or low risk aversion? Unfortunately, it is difficult to measure investor risk aversion with a single number. One way to get a broad idea of risk aversion levels is to look at the different yields that bonds pay. The wider the difference, or spread, between bonds of different credit ratings, the higher the investor risk aversion. Bond yields can be found in most financial newspapers. In addition, several large banks have developed their own measures of risk aversion that signal when investors are willing to take risks and when they are not.
Other Things to Bear in Mind When Considering a Carry Trade
While risk aversion is one of the most important things to consider before making a carry trade, it is not the only one. The following are some additional issues to be aware of.
FIGURE Risk Aversion and Carry Trade Profitability
Low-Interest-Rate Currency Appreciation By entering into a carry trade, an investor is able to earn a profit from the interest rate difference, or spread, between a high-interest-rate currency and a low-interest-rate currency. However, the carry trade can turn unprofitable if for some reason (like the earlier risk aversion example) the low-interest-rate currency appreciates by a large amount.
Aside from increases in investor risk aversion, improving economic conditions within a low-interest-paying country can also cause its currency to appreciate. An ideal carry trade involves a low-interest currency whose economy is weak and has low expectations for growth. If the economy were to improve, however, the country might then be able to offer investors a higher rate of return through increased interest rates. If this were to occur—again using the earlier example, say that Switzerland increased the interest rates it offered—then investors may take advantage of these higher rates by investing in Swiss francs. As seen in Figure, an appreciation of the Swiss franc would negatively affect the profitability of the Australian dollar–Swiss franc carry trade. (At the very least, higher interest rates in Switzerland would negatively affect the carry trade’s profitability by lowering the interest rate spread.)
To give another example, this same sequence of events may currently be unfolding for the Japanese yen. Given its zero interest rates, the Japanese yen has for a very long time been an ideal low-interest-rate currency to use in carry trades (known as “yen carry trades”). This situation, however, may be changing. Increased optimism about the Japanese economy has recently led to an increase in the Japanese stock market. Increased investor demand for Japanese stocks and currency has caused the yen to appreciate, and this yen appreciation negatively affects the profitability of carry trades like Australian dollar (high interest rate) versus Japanese yen.
If investors continue to buy the yen, the “yen carry trade” will grow more and more unprofitable. This further illustrates the fact that when the low-interest-rate currency in a carry trade (the currency being sold) appreciates, it negatively affects the profitability of the carry trade.
Trade Balances Country trade balances (the difference between imports and exports) can also affect the profitability of a carry trade. We have shown that when investors have low risk aversion, capital will flow from the low-interest-rate-paying currency to the high-interest-rate-paying currency. This, however, does not always happen.
To understand why, think about the situation in the United States. The United States currently pays historically low interest rates, yet it attracts investment from other countries, even when investors have low risk aversion (i.e., they should be investing in the high-interest-rate countries). Why does this occur? The answer is because the United States runs a huge trade deficit (its imports are greater than its exports)—a deficit that must be financed by other countries. Regardless of the interest rates it offers, the United States attracts capital flows to finance its trade deficit. The point of this example is to show that even when investors have low risk aversion, large trade imbalances can cause a low-interest-rate currency to appreciate. And when the low-interest-rate currency in a carry trade (the currency being sold) appreciates, it negatively affects the profitability of the carry trade.
Time Horizon In general, a carry trade is a long-term strategy. Before entering into a carry trade, an investor should be willing to commit to a time horizon of at least six months. This commitment helps to make sure that the trade will not be affected by the “noise” of shorter-term currency price movements. Also, not using excessive leverage for carry trades will allow traders to hold onto their positions longer and to better weather market fluctuations by not getting stopped out.
To summarize: Carry trade investors should be aware of factors such as currency appreciation, trade balances, and time horizon before placing a trade. Any or all of these factors can cause a seemingly profitable carry trade to become unprofitable.
FUNDAMENTAL TRADING STRATEGY: STAYING ON TOP OF MACROECONOMIC EVENTS
Short-term traders seem to be focused only on the economic release of the week and how it will impact their day trading activities. This works well for many traders, but it is also important not to lose sight of the big macro events that may be brewing in the economy—or the world for that matter. The reason is because large-scale macroeconomic events will move markets and will move them big time. Their impact goes beyond a simple price change for a day or two because depending on their size and scope, these occurrences have the potential to reshape the fundamental perception toward a currency for months or even years at a time. Events such as wars, political uncertainty, natural disasters, and major international meetings are so potent due to their irregularity that they have widespread psychological and physical impacts on the currency market. With these events come both currencies that appreciate vastly and currencies that depreciate just as dramatically. Therefore, keeping on top of global developments, understanding the underlying direction of market sentiment before and after these events occur, and anticipating them could be very profitable, or at least can help prevent significant losses.
Know When Big Events Occur
- Significant G-7 or G-8 finance ministers meetings.
- Presidential elections.
- Important summits.
- Major central bank meetings.
- Potential changes to currency regimes.
- Possible debt defaults by large countries.
- Possible wars as a result of rising geopolitical tensions.
- Federal Reserve chairman’s semiannual testimony to Congress on the economy.
The best way to highlight the significance of these events is through examples.
G-7 Meeting, Dubai, September 2003
The countries that constitute the G-7 are the United States, United Kingdom, Japan, Canada, Italy, Germany, and France. Collectively, these countries account for two-thirds of the world’s total economic output. Not all G-7 meetings are important. The only time the market really hones in on the G-7 finance ministers meeting is when big changes are expected. The G-7 finance ministers meeting on September 22, 2003, was a very important turning point for the markets. The dollar collapsed significantly following the meeting at which the G-7 finance ministers wanted to see “more flexibility in exchange rates.” Despite the rather tame nature of these words, the market interpreted this line to be a major shift in policy. The last time changes to this degree had been made was back in 2000.
In 2000, the market paid particular attention to the upcoming meeting because there was strong intervention in the EUR/USD the day before the meeting. The meeting in September 2003 was also important because the U.S. trade deficit was ballooning and becoming a huge issue. The EUR/USD bore the brunt of the dollar depreciation while Japan and China were intervening aggressively in their currencies. As a result, it was widely expected that the G-7 finance ministers as a whole would issue a statement that was highly critical of Japan’s and China’s intervention policies. Leading up to the meeting, the U.S. dollar had already begun to sell off. At the time of the announcement, the EUR/USD shot up 150 pips. Though this initial move was not very substantial, between September 2003 and February 2004 (the next G-7 meeting), the dollar fell 8 percent on a trade-weighted basis, 9 percent against the British pound, 11 percent against the euro, 7 percent against the yen, and 1.5 percent against the Canadian dollar. To put the percentages into perspective, a move of 11 percent is equivalent to approximately 1,100 pips. Therefore the longer-term impact is much more significant than the immediate impact, as the event itself has the ability to change the overall sentiment in the market. A weekly chart of the EUR/USD that illustrates how the currency pair performed following the September 22, 2003, G-7 meeting.
FIGURE EUR/USD Post G-7 Chart
Political Uncertainty: 2004 U.S. Presidential Election
Another example of a major event impacting the currency market is the 2004 U.S. presidential election. In general, political instability causes perceived weakness in currencies. The hotly contested presidential election in November 2004 combined with the differences in the candidates’ stances on the growing budget deficit resulted in overall dollar bearishness. The sentiment was exacerbated even further given the lack of international support for the incumbent president (George W. Bush) due to the administration’s decision to overthrow Saddam Hussein. As a result, in the three weeks leading up to the election, the euro rose 600 pips against the U.S. dollar. With a Bush victory becoming increasingly clear and later confirmed, the dollar sold off against the majors as the market looked ahead to what would probably end up being the maintenance of the status quo. On the day following the election, the EUR/USD rose another 200 pips and then continued to rise an additional 700 pips before peaking six weeks later. This entire move took place over the course of two months, which may seem like eternity to many, but this macroeconomic event really shaped the markets; for those who were following it, big profits could have been made. However, this is important even for shortterm traders because given that the market was bearish dollars in general leading up to the U.S. presidential election, a more prudent trade would have been to look for opportunities to buy the EUR/USD on dips rather than trying to sell rallies and look for tops.
FIGURE EUR/USD U.S. Election
Wars: U.S. War in Iraq
Geopolitical risks such as wars can also have a pronounced impact on the currency market. Shows that between December 2002 and February 2003, the dollar depreciated 9 percent against the Swiss franc (USD/CHF) in the months leading up to the invasion of Iraq. The dollar sold off because the war itself was incredibly unpopular among the international community. The Swiss franc was one of the primary beneficiaries due to the country’s political neutrality and safe haven status. Between February and March, the market began to believe that the inevitable war would turn into a quick and decisive U.S. victory, so they began to unwind the war trade. This eventually led to a 3 percent rally in USD/CHF as investors exited their short dollar positions.
Each of these events caused large-scale movement in the currency markets, which makes them important events to follow for all types of traders. Keeping abreast of broad macroeconomic events can help traders make smarter decisions and prevent them from fading large uncertainties that may be brewing in the background. Most of these events are talked about, debated, and anticipated many months in advance by economists, currency analysts, and the international community in general. The world changes and currency traders need to be prepared for that.
FIGURE USD/CHF War Trade
COMMODITY PRICES AS A LEADING INDICATOR
Commodities, namely gold and oil, have a substantial connection to the FX market. Therefore, understanding the nature of the relationship between them and currencies can help traders gauge risk, forecast price changes, as well as understand exposure. Even if commodities seem like a wholly alien concept, gold and oil especially tend to move based on similar fundamental factors that affect currency markets. As we have previously discussed, there are four major currencies considered to be commodity currencies—the Australian dollar, the Canadian dollar, the New Zealand dollar, and the Swiss franc. The AUD, CAD, NZD, and CHF all have solid correlations with gold prices; natural gold reserves and currency laws in these countries result in almost mirror-like movements. The CAD also tends to move somewhat in line with oil prices; however, the connection here is much more complicated and fickle. Each currency has a specific correlation and reason as to why its actions reflect commodity prices so well. Knowledge of the fundamentals behind these movements, their direction, and the strength of the parallel could be an effective way to discover trends in both markets.
Gold Before analyzing the relationship gold has with the commodity currencies, it is important to first understand the connection between gold and the U.S. dollar. Although the United States is the world’s second largest producer of gold (behind South Africa), a rally in gold prices does not produce an appreciation of the dollar. Actually, when the dollar goes down, gold tends to go up, and vice versa. This seemingly illogical occurrence is a by-product of the perception investors hold of gold. During unstable geopolitical times, traders tend to shy away from the dollar and instead turn to gold as a safe haven for their investments. In fact, many traders call gold the “antidollar.” Therefore, if the dollar depreciates, gold gets pushed up as wary investors flock from the declining greenback to the steady commodity. The AUD/USD, NZD/USD, and USD/CHF currency pairs tend to mirror gold’s movements the closest because these other currencies all have significant natural and political connections to the metal.
Starting in the South Pacific, the AUD/USD has a very strong positive correlation (0.80) with gold; therefore, whenever gold prices go up, the AUD/USD also tends to go up as the Australian dollar appreciates against the U.S. dollar. The reason for this relationship is that Australia is the world’s third largest producer of gold, exporting about $5 billion worth of the precious metal annually. Because of this, the currency pair amplifies the effects of gold prices twofold. If instability is causing an increase in prices, this probably signals that the USD has already begun to depreciate. The pairing will then be pushed down further as importers of gold demand more of Australia’s currency to cover higher costs. The New Zealand dollar tends to follow the same path in the AUD/USD pairing because New Zealand’s economy is very closely linked to Australia’s. The correlation in this pairing is also approximately 0.80 with gold. The CAD/USD has an even stronger correlation with gold prices at 0.84, caused in large part by analogous reasons to the AUD’s connection; Canada is the fifth largest exporter of gold.
In Europe, Switzerland’s currency has a strong relationship with gold prices as well. However, the CHF/USD pairing’s 0.88 correlation with the metal is caused by different reasons than the NZD’s, AUD’s, and CAD’s connections. Switzerland does not have substantial natural gold reserves like Australia or Canada and therefore it is not a notable exporter of the metal. However, the Swiss franc is one of the few major currencies that still adheres to the gold standard. A full 25 percent of Switzerland’s bank issue notes are backed in gold reserves. This solid currency base makes it no mystery as to why the CHF is perceived as a currency safe haven in unstable times. During times of geopolitical uncertainties, the Swissie tends to rally. An example of this could be found in the U.S. buildup to the war in Iraq. Many investors drew their money out of the USD and invested heavily in both gold and the CHF.
FIGURE AUD/USD and Gold
Thus, a trader who notes a rising trend in gold prices (or in other metals such as copper or nickel) might be wise to go long any one of the four commodity currencies instead. One interesting incentive to go long the AUD/USD instead of gold is the unique ability of expressing the same view but also being able to earn positive carry. Gold is also usually a solid indicator of the overall picture in the metals markets.
Oil Oil prices have a huge impact on the world economy, affecting both consumers and producers. Therefore the correlation between this commodity and currency prices is much more complex and less stable than that of gold. In fact, out of all of the commodity currencies, only one (the CAD) has any semblance of a connection with oil prices.
FIGURE NZD/USD and Gold
The USD/CAD has a correlation of –0.4, a fairly weak number indicating that a rally in oil prices will result in a rally in the Canadian dollar only some of the time. Throughout the second half of 2004 and first half of 2005, this correlation has been much stronger. Although Canada is the world’s fourteenth largest producer of oil, oil’s effect on its economy is much more all-encompassing than gold’s. While gold prices do not have a substantial spillover into other areas, oil prices most definitely do. Canada especially has trouble due to its cold climate, which creates a large amount of demand for heating oil most of the year. Moreover, Canada is particularly susceptible to poor foreign economic conditions because it depends heavily on exports. Therefore, oil has a very mixed effect on the Canadian dollar. Most of this is dependent upon how U.S. consumer demand responds to rising oil prices. Canada’s economy is closely tied to its southern neighbor since 85 percent of its exports are destined for the United States.
Now that the relationships have been explained, there are two ways to exploit this knowledge. Taking a look at figures you can see that generally speaking, commodity prices are a leading indicator for currency prices. This is most apparent in the NZD/USD–gold relationship and the CAD/USD–oil relationship. As such, commodity block traders can monitor gold and oil prices to forecast movements in the currency pairs. The second way to exploit this knowledge is to parlay the same view using different products, which does help to diversify risk a bit even with the high correlation. In fact, there is one key advantage to expressing the view in currencies over commodities, and that is that it offers traders the ability to earn interest on their positions based on the interest rate differential between the two countries, while gold and oil futures positions do not.
FIGURE CAD/USD and Oil
USING BOND SPREADS AS A LEADING INDICATOR FOR FX
Any trader can attest that interest rates are an integral part of investment decisions and can drive markets in either direction. FOMC rate decisions are the second largest currency-market-moving release, behind unemployment data. The effects of interest rate changes have not only short-term implications, but also long-term consequences on the currency markets. One central bank’s rate decision can affect more than a single pairing in the interrelated forex market. Yield differentials fixed income instruments such as London Interbank Offered Rates (LIBOR) and 10-year bond yields can be used as leading indicators for currency movements. In FX trading, an interest rate differential is the difference between the interest rate on a base currency (appearing first in the pair) less the interest rate on the quoted currency (appearing second in the pair). Each day at 5:00 p.m. EST, the close of the day for currency markets, funds are either paid out or received to adjust for interest rate differences. Understanding the correlation between interest rate differentials and currency pairs can be very profitable. In addition to central bank overnight rate decisions, expected future overnight rates along with the expected timing of rate changes are also critical to currency pair movements. The reason why this works is that the majority of international investors are yield seekers. Large investment banks, hedge funds, and institutional investors have the ability capital-wise to access global markets. Therefore, they are actively shifting funds from lower-yielding assets to higher-yielding assets.
Interest Rate Differentials: Leading Indicator, Coincident Indicator, or Lagging Indicator?
Since most currency traders consider present and future interest rate differentials when making investment decisions, there should theoretically be some correlation between yield differences and currency pair prices. However, do currency pair prices predict rate decisions, or do rate decisions affect currency pair prices? Leading indicators are economic indicators that predict future events; coincident indicators are economic indicators that vary with economic events; lagging indicators are economic indicators that follow an economic event. For instance, if interest rate differentials predict future currency pair prices, interest rate differentials are said to be leading indicators of currency pair prices. Whether interest rate differentials are a leading, coincident, or lagging indicator of currency pair prices depends on how much traders care about future rates versus current rates. Assuming efficient markets, if currency traders care only about current interest rates and not about future rates, one would expect a coincident relationship. If currency traders consider both current and future rates, one would expect interest rate differentials to be a leading indicator of future currency prices.
The rule of thumb is that when the yield spread increases in favor of a certain currency that currency will generally appreciate against other currencies. For example, if the current Australian 10-year government bond yield is 5.50 percent and the current U.S. 10-year government bond yield is 2.00 percent, then the yield spread would be 350 basis points in favor of Australia. If Australia raised its interest rates by 25 basis points and the 10- year government bond yield appreciated to 5.75 percent, then the new yield spread would be 375 basis points in favor of Australia. Based on historical evidence, the Australian dollar is also expected to appreciate against the U.S. dollar in this scenario.
Based on a study of three years of empirical data starting from January 2002 and ending January 2005, we find that interest rate differentials tend to be a leading indicator of currency pairs.
FIGURE AUD/USD and Bond Spread
FIGURE GBP/USD and Bond Spread
FIGURE USD/CAD and Bond Spread
These figures show three examples of currency pairs where bond spreads have the clearest leading-edge correlation. As one would expect from the fact that traders trade on a variety of information and not just interest rates, the correlation, though good, is not perfect. In general, interest rate differential analysis seems to work better over a longer period of time. However, shifts in sentiment for the outlook for the path of interest rates over the shorter term can still be a leading indicator for currency prices.
Calculating Interest Rate Differentials and Following the Currency Pair Trends
The best way to use interest rate differentials for trading is by keeping track of one-month LIBOR rates or 10-year bond yields in Microsoft Excel. These rates are publicly available on web sites such as Bloomberg.com. Interest rate differentials are then calculated by subtracting the yield of the second currency in the pair from the yield of the first. It is important to make sure that interest rate differentials are calculated in the order in which they appear for the pair. For instance, the interest rate differentials in GBP/USD should be the 10-year gilt rate minus the 10-year U.S. Treasury note rate. For euro data, use data from the German 10-year bond. Form a table that looks similar to the one.
After sufficient data is gathered, you can graph currency pair values and yields using a graph with two axes to see any correlations or trends. Use the date in the x-axis and currency pair price and interest rate differentials on two y-axis graphs. To fully utilize this data in trading, you want to pay close attention to trends in the interest rate differentials of the currency pairs you trade.
TABLE Bond Spreads