There are a lot of nations in the world and consequently a large number of currencies to choose from when trading. The currencies of Brazil, Russia, China, the Eurozone, Turkey, Japan, South Africa and Canada are popular with large and small traders, for different reasons. What the market values most in a trade can change depending on government policies and the global economic environment. For example, during the flowery days of the carry trade, many traders would simply long (buy) the currency offering the highest interest rate, and short (sell) the one offering the lowest interest rate, with little consideration given to the underlying economic soundness. Such a strategy is less likely to be profitable in today’s chaotic environment with interest rates racing lower across the globe, and fundamental economic strength is once again the major concern in deciding on currency allocations.
In order to simplify the matter, let us group the currencies into four types and examine each of them briefly:
There’s really only one true reserve currency in the world with dominance of about two-thirds of central bank accounts, and it is the US dollar, the currency of international trade. But there are also others, such as the Swiss Franc, Japanese Yen and to a greater extent, the Euro, which play the same role, and as such are of higher quality and offer greater safety in times of trouble.
These are currencies of nations with a heavy dependence on commodity exports, such as the Canadian and Australian dollars or the Brazilian real, and their performance is closely related to the performance of the global commodity markets.
These are currencies of the likes of Singapore, Malaysia, Taiwan, or China — although it’s difficult to trade the Ren Min Bi (RMB) due to capital controls — with healthy external trade surpluses. These nations often have a high private and corporate savings ratio, and are better placed to survive periods of financial difficulties as they have little need for external borrowing. As exporters, they will most often choose to keep their currencies priced lower against competitors to keep their products more competitive in the global markets.
High risk, high deficit, high yield currencies
In analogy with the bond market, one could also term these currencies junk currencies, in that the economies are usually dependent on external financing, with greatest domestic activity concentrated in real estate, finance, and tourism-related industries. Many emerging markets are members of this group, but there are also other, relatively advanced nations such as (alas!) the UK, or Iceland, which nowadays can be considered to belong to this category. Further examples would be Turkey, Romania and Hungary — as a group, they have suffered the worst of the troubles of 2008.
What use is this categorization to the trader? It’s mainly for those who want some diversification in their currency portfolios, in accordance with the ancient wisdom of not putting all eggs in the same basket. The above categories suggest that good diversification cannot be achieved by, for example, allocating long positions to both the Turkish lira, and the Romanian leu in the same account, as both of these currencies share the junk status. Nor can the trader claim to diversify his positions by buying the Brazilian real, and selling both the Swiss franc and the Japanese yen to fund the purchase. Both the franc and the yen are exporter currencies, and they are likely to make similar moves in response to financial developments. Forex brokers and websites sometimes offer correlation charts (which depict the price relationship between currency pairs during a specific time period), and the interested reader can learn more on this subject by studying them. But in general, positions in different currencies in a single category are likely to react like a single position of a single currency to market events; the trader should always keep this in mind when managing his account.
- USD – U.S. Dollar
- EUR- European Union Euro
- JPY- Japanese Yen
- GBP – U.K. Pound Sterling
- CHF – Swiss Franc