Tag Archives: exchange rate

Ain't it always the case that an exchange rate rallies into your trip, then starts falling after you've spent the lion's share of the money? GBP/USD did that to me. It was looking so good early in January when the rate was down the low 1.50s, but by I time I left for my trip to England last week the rate was looking at testing 1.60. What day did the market peak? The day I checked out of my longest hotel stay, of course (insert your favorite string of curse words here).

What's even more annoying is that GBP/USD really looks like it's set up for a tumble.

On the weekly chart below we can see the clear support along the line going back to the lows from September 2010 near 1.5300. That was broken during the last leg down, but the market quickly reversed back higher. It hasn't been able to push those gains to even create a test of the November peak, however, so the pattern of lower highs and lows since the 2011 highs remains in place.

GBPUSD Chart

 

These lower highs are also building a head-and-shoulders type of pattern on the chart. If we consider the peak of the pattern to be about at 1.6735, that gives us over 1400 pips in downside projection using the head-to-neckline measurement. A simple target would thus be about 1.3900. This is quite aggressive given the likely support above 1.4000 based on the 2010 lows, but it does provide a fair bit of scope as to the type of damage that could be done should GBP/USD manage a sustained break of 1.5300.

So what's the catalyst for that kind of action? The BoE has already announced GBP50bln of additional QE. That has largely already been priced in and the market isn't looking for any big additions at this point. The biggest risk factor at this point is a crank back up of the risk-off market psychology that would drive the dollar higher. If we see the S&P 500 fail to overcome the 2011 highs as part of the current rally, that becomes a very real risk.

This couldn't have happened a bit sooner?

 

With the start of 2012 comes the start of the strongest "seasonal" trading pattern of the year for the US dollar. That would be the one for the month of January. Going back to 1982, the first month of the year has been up 2/3rds of the time, averaging a gain of 0.89%. For those who have a statistics bent, T-Test analysis indicates this is significant at a 97% confidence level. (It should be noted that I'm not actually talking about the USD Index here, but rather an equal weight index calculated using the USD exchange rate against the other majors, though indications suggest the results for the USD Index are quite similar).

And for those who think these sorts of patterns degrade over time, consider the fact that the USD has been up 9 out of 13 Januarys since the launch of the euro in 1999, with a very similar average monthly change. This figure isn't as statistically significant because it includes fewer observations, but it's meaningful never the less.

Why is this the case?

I can't give you a definitive answer, as I'm not involved in that side of the business, but I can venture what I think is a good educated guess. It likely has a lot to do with the corporate capital flows as US multi-nationals repatriate overseas earnings as they close up the books for the year gone by. There's been a lot of talk in recent years about money sitting overseas to avoid US taxation, but that's likely overstated.

So why is this important?

Given the recent negative correlation between the USD and stock prices and interest rates, the expectation of a rising dollar during January would tend to suggest weaker stocks and lower yields. Just keep in mind, though, that correlations change. As the chart below shows, the correlation between the USD Index and the S&P 500 (lower red plot) has been moving toward 0 of late and actually got well into positive territory a couple times in 2011.

USD Seasonal Chart

 

The other risk management consideration is that a strong seasonal pattern is no guarantee. The dollar may have been up 20 out of 30 months, but that means 10 out of 30 it wasn't, so caution is always warranted. As with other markets, forex seasonal patterns are good for biasing, but risky to use outright.

 

 

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As we’ve said before, we’re all invested in the currency market in one way or another. But it wasn’t all that long ago that investment access to the currency market was limited to sophisticated high-net-worth individuals, for the most part. Technological developments and market innovations, however, have opened the market up to just about anyone who wants to take part these days. It’s not as risky as they say – and here are five ways that you can participate. And don’t forget to check out the free e-book “The Smarties’ Guide to Alternative Investing in the Foreign Exchange Market” for more practical wisdom.

1. Investing in Cash Currencies

The simplest form of foreign exchange investing is swapping your home currency (e.g. dollars) for some other. This allows you to benefit from the gains that other currency might make against your own. For example, if you think the dollar is too highly valued against the British pound you could exchange your dollars for pounds, eventually converting back when you think the two currencies are more properly valued. Your profit would be the amount of appreciation the pound experienced in dollar terms.

This sort of “cash” currency investing can easily be done by going to the bank and exchanging your dollars for the other currency of your liking. There are foreign and multi-currency accounts available as well so you don’t have to actually hold pounds or euros or yen in actual cash and can potentially allow for investment in foreign securities. The one thing to keep an eye on, though, is the exchange rate spreads. They are often much wider than market rates when doing small retail transactions of this sort.

2. Currency Investment Vehicles

If you don’t want to worry about the details of currency exchanges and accounts there are other options. The ones that get the most press are currency exchange traded funds and notes (ETFs and ETNs), which trade like stocks. For example, Rydex has a collection of ETFs that invest directly in specific currencies and pay interest based on the rate of the currency in question. There are also mutual funds doing the same thing. Since these are registered securities they are generally eligible for inclusion in retirement and other institutional types of accounts.

As is always the case with these types of vehicles, however, you need to know the specifics. Some of these instruments are single currency, while others are blends. Some aren’t just currency holdings, but actually have managed strategies involved. Make sure you get what you’re after. Also, remember to account for transaction costs when considering these sorts of securities. Recall from the earlier table that ETFs are subject to both commissions and market spreads. Plus, there are fund management fees for both ETFs and mutual funds.

3. Foreign Bond and Stock Funds

A less direct way of playing the currency market is doing so through mutual funds, ETFs, and other vehicles that invest in foreign securities. These sorts of investments have inherent exchange rate exposure because your money is converted into the currency of the country (or countries) in which you are investing. To get an idea of how much impact currency valuations can have on investment performance, take a look at this chart comparing the S&P 500 with the German DAX, with the latter expressed in dollar terms.

German DAX index performance in US Dollar terms compared to the S&P 500. Source: Google Finance

It is worth noting that the DAX did not meaningfully break the 2000 peak in 2007 of its own accord. It’s the impact of the weaker dollar against the euro which produces that higher 2007 peak in the chart above. It should be noted if you’re thinking about investing in foreign stocks via mutual funds, that some hedge that exchange rate exposure. As noted above, you need to make sure to check the specifics before putting your money down.

4. Forex Brokers

Playing the foreign exchange market via a broker has become very popular in the last decade. Where ETFs and the other trading vehicles tend to be more general currency plays, brokers allow traders and investors to play specific currency exchange rates through pairs. For example, through a broker you can trade the euro-dollar exchange rate. Moreover, you can trade the rates between currencies that are not your own. For example, as US trader could play the Canadian dollar-Japanese yen exchange rate. This can all be done in cash currency transactions, of course, but trading through a broker is faster thanks to online access, more flexible, and generally cheaper because of lower spreads.

It is in this broker-based trading where the reputation for serious risk has come into Forex, though, thanks to the readily available access to high leverage. Trading in this way is very similar to trading in the futures markets in terms of transacting in contracts for delivery rather than direct currency exchange, and in dealing with leverage and margin. As such, it’s not as simple and straightforward as cash market investing. It does, however, allow you the opportunity to play a wider array of exchange rates than just those against the dollar. It also opens up the opportunity to apply leverage to take somewhat larger risks if that suits your objectives.

5. The Carry Trade

The carry trade is something that gets talked about in the markets at different points. Basically, this is borrowing money in one currency, exchanging it for another one, and investing the proceeds. The idea is to borrow a low interest rate currency and put it into a currency where the rates of return are higher. The objective is to make the spread between what you pay on the borrowed funds and what you earn on the other end of the position.

For example, an investor could borrow Japanese yen because Japanese interest rates are very low. Rates in Australia are significantly higher, so those yen could be swapped into Australian dollars and invested in short-term fixed income securities. If the rate to borrow the yen is 0.5% and the rate paid by the Aussie dollar investment is 3.0% you make the 2.5% difference.

Of course at some point you’ll have to convert your dollars back to yen to pay off that loan. That means you have exposure to the exchange rate between the two currencies (AUD/JPY). If that rate goes against you it could more than wipe out what you make on the rate spread.

It’s that old saying: There’s no free lunch.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.