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Hidden opportunities outside of major currency pairs
Forex is the most actively traded market in the world with over $5 trillion worth of volume on an average day – about 25 times more than the average volumes in the global equities market.
While different currencies play different roles in the market, with some holding unique characteristics (like the world’s reserve currency, the US dollar), most currency pairs are often influenced by the same drivers that centre around supply and demand, central banks, economic data, credit ratings, foreign affairs and, as always, pure sentiment.
FX trading is dominated by the world’s seven major currency pairs, but the rapidly changing political and economic picture in some parts of the world mean there is plenty of opportunity hidden within other minor or exotic currency pairs.
Politics and forex trading
Shifts in political attitude can cause the most severe currency movements, demonstrated by sterling’s behaviour since the EU Referendum result in June 2016. There are a number of countries that have elections coming up this year - like Italy, Mexico and Brazil - that open the opportunity for forex traders.
Take Mexico and the pesos as an example. In January 2017, just before Donald Trump took residence in the White House, USD/MXN had strengthened to its all-time record high.
But with the US President threatening to impose tariffs against Mexico, which exports about 80% of its goods to the US, and to bring back jobs that have been lost to its neighbour, the confidence behind the pesos has been severely knocked.
Mexico’s central bank has already tried hiking interest rates as part of several vain attempts to support a pesos that was being heavily hampered by volatility. But with interest rates currently sitting at a nine-year high, Mexico’s central bank has tried to intervene in different ways since Trump took office.
However, with the future of Mexicans living in the US still uncertain, prototype border walls springing up, and a need for the North American Free Trade Agreement (NAFTA) to be sewed back together after the US was torn away by Trump, the renewed volatility in this currency pair could be set to continue for the foreseeable future.
Mexico’s presidential election this July has the potential to throw a match into the box of fireworks, as it is likely that a victor will emerge with a third or less of the public vote.
Meanwhile, USD/ZAR has become an interesting pair since the recent shake-up within South Africa. The rand took a heavy knock in November last year following S&P’s decision to downgrade South Africa’s local debt to ‘junk’, and has been under increasing pressure amid rising US interest rates.
However, with Jacob Zuma recently ousted after nine scandal-ridden years, the jury is still out on whether the future of South Africa looks better or worse under Cyril Ramaphosa – and this is likely to keep the rand lively as his policy unfolds.
Commodities and currency
Commodity prices are centred on supply and demand, and therefore experience significant reactions to data on growth from the world’s biggest economies. Second-place China is used as an indicator of growth in the wider emerging markets, while the US, representing the biggest economy in the world, is used as an indicator of growth in advanced markets.
While Trump’s more protectionist attitude has stretched US-China relations at times, the impact of any policy will have ramifications for the global economy. These two economies are heavily intertwined but are individually driven by very different factors, which makes USD/CNH more volatile.
With the US poised to introduce tariffs on the likes of steel and aluminium, Trump’s displeasure with trading deficits, and his ambition to restart the industrial hubs that lie close to his voter’s hearts, means US policy will weigh heavily on metal prices and closely-linked currencies going forward.
Depending on how much it contributes to its own economy and to global supply, some countries have currencies that are intrinsically linked to major commodities they produce. Being linked to a commodity means a currency like the South African rand gains or loses momentum as precious metal prices head higher or lower, while the Canadian dollar has a similar relationship with crude oil and timber.
The New Zealand dollar is influenced by soft commodities in agriculture, as is the Australian dollar, which is also heavily impacted by movements in industrial metals prices due to its vast mining sector.
Commodity currency pairs
Commodity currencies carry close relationships with their respective commodity, meaning trends in commodity markets can provide forex traders with an insight into how these currencies may behave going forward.
It also creates commodity currency pairs that forex traders can play off one another, such as AUD/NZD to trade industrial commodities over agricultural ones, or AUD/CAD for metals over oil.
However, all of these currencies are still swayed by other political and economic matters, meaning commodity currencies are not a ‘pure play’ on commodity prices. The Canadian dollar holds the US economy dear, for example, while central banks play a major role in shaping how all major currencies pan out.
Currency pairs based on carry trades
Central banks and changes in interest rates are key to forex trading. The carry trade is one of the most popular, whereby a currency with a relatively low interest rate is sold in order to buy a currency boasting a higher interest rate.
At its simplest level, the aim is to book the difference in interest rates as profit. However, the risk lies in the subsequent movements between the two currencies that have been traded, which can cause losses.
Let’s stick with commodities for this example. The growth that countries with vast natural resources can experience, and the rally in their currency when commodity prices are strengthening and global growth is ticking along, can see domestic interest rates pushed higher. This would make the currency appealing to those conducting carry trades, which in turn helps to drive up the price of the currency.
The spread between different interest rates around the world is important for the carry trade, and this changes as central banks shift their monetary policies. The Bank of Canada (BoC) has already bumped-up rates this year and, following the lifts made by both last year, the Federal Reserve (Fed) and Bank of England (BoE) are forecast to raise rates, potentially on several occasions, in 2018.
Out of the eight major central banks, the Bank of Japan (BoJ) currently has the lowest interest rate of -0.1% as of early 2018, while the Reserve Bank of New Zealand (RBNZ) has the highest at 1.75%, making NZD/JPY potentially the most profitable carry trade available at present. Although, Australia’s interest rate means AUD/JPY is a close second. Still, with the Fed eyeing higher rates, USD/JPY will still be the most liquid and attractive option.