What are currency markets?
The currency, or foreign exchange, market is where all currencies are bought, sold or exchanged. In terms of volume, it is by far the largest market in the world, with over $4 trillion changing hands on average every day. It is what’s known as an over—the—counter (OTC) market — a decentralised market in which large international banks and other institutions trade electronically.
Individual currencies do not have an absolute value. Instead, currencies are always traded in pairs, and each currency has a relative value that’s set as the market price of one currency, if paid for with another currency. For example, the pound sterling versus the US dollar, the dollar versus the Japanese yen, the yen versus the euro, and so on.
If you believe the US dollar will strengthen against the pound, then as a UK trader you can use your home currency to buy dollars. If, however, you believe the opposite, then you need to use a stock of dollars to buy pounds.
Investing in currency markets
Investing in currency is something that UK investors do all the time, though not in currency markets. Anyone invested in the FTSE 100 stock index (where 75% of earnings made by the constituent companies come from overseas), or in global funds and investment trusts, enjoyed a Brexit bonus in 2016—17 when the pound plunged after the EU referendum. It demonstrated how currency markets can make a difference to an investment strategy.
UK portfolios which were heavy in overseas assets raced ahead by an average 13% in 2016, well ahead of even the buoyant 8.2% returns enjoyed by US investors according to a Global Portfolio Barometer from fund group Natixis.
It was currency—related returns rather than underlying equity markets which drove 7% — or more than half — of that performance, adding 19% to returns for UK investors from US equities, with a 16% uplift for European and 23% for Japanese equities. Emerging market debt and high—yield debt also benefited.
Which goes to show that every investor needs to understand currency markets and how they impact other markets. Luckily, there’s plenty you can do to try and offset the impact of currency fluctuations on your portfolio even if you’re not actively investing in currencies.
What moves currency markets?
As we know when we travel, exchange rates change and can do so quickly. Buying our dollars or euros a few weeks or months ahead may save money — but only if we have guessed market movements correctly.
Currencies are buffeted hourly by global news and events, from central bank announcements to natural disasters.
Investing means taking a longer—term view and ignoring the short—term fluctuations in the markets, but it still means understanding currency markets and the direction currencies may take in the longer term. Even the most stable currencies, the world’s so called reserve currencies like the US dollar, can move a lot over time, and that can have a big impact on a portfolio.
Which are the best currencies to invest in?
As with any investment, there’s no such thing as a best currency to invest in. Some will rise and some will fall at any given time. And forex markets can be volatile and are considered at the high—risk end of the investment scale. However, certain currencies have characteristics that will help you identify whether they have a place in your portfolios.
For example, currencies like the Australian and Canadian dollars have a strong relationship with commodity prices because the economies of those countries are relatively highly dependent on commodities. When commodity prices are falling, you’d expect the Australian and Canadian economies to fare worse and therefore their currencies to decline.
The US dollar is known as the world’s reserve currency. Everything from barrels of oil to consumer goods can be bought on the world markets using the currency also known as the ‘greenback’. Its main drivers are varied, but the health of the world economy, US politics and US central bank policies play a big part.
Emerging market currencies — those from countries including India, Brazil, South Africa, and Russia — tend to be more volatile than the currencies of developed markets. They can offer the promise of strong growth, but then quite suddenly be affected by domestic political unrest, tightening in global debt markets, or commodity price falls.
Investing in currencies using ETFs
A simple way to tap into currency movements is via exchange traded funds (ETFs).
These hold cash or futures contracts in one currency, or in a basket of currencies, to track the underlying movement as closely as possible. Management fees are low, and trading ETFs is easy.
For instance, if you think you know how the pound will move against the dollar over the next period of time, you can buy the ETFS Long British Pound Short US Dollar ETC (Sterling) ETF or its mirror image.
You might also want to look at how to short—trade ETFs as a way of protecting your portfolio against currency shocks.
ETFs can be held within a tax wrapper like a SIPP or ISA, though non—UK ETFs may not be eligible for an ISA.