Choosing Your Currency Pairs: Cross Currency Pairs

posted in: Forex | 0

Now we move from the major currency pairs to the cross currency pairs, and this essentially means any pair which does not have the US dollar. Many books at this stage might suggest that as a novice trader you stick to the majors and avoid the cross currency pairs. I do not subscribe to this view for several reasons.

It is certainly true that the spreads on the major pairs will be tighter than in the cross currency pairs, and this is generally the reason cited for trading these in preference to the cross pairs. However, this aside, there are many reasons for considering these pairs, even as a novice, provided you understand the characteristics of each, and accept some basic principles, such as wider spreads and a little less liquidity, which can make some of them more volatile.

However, against this, I would suggest the following argument.

It is a fact of life in the foreign exchange markets that 2007 changed the market, and the old values and methodologies have been swept aside as a result. Prior to these events, currency markets, broadly speaking, were ‘free floating’, where exchange rates were left to find their own levels, based on fundamentals, money flow, risk, supply, and demand? In other words, a free market economy if you like, where simple market forces dictated the ultimate exchange rates. This was the principle on which the gold standards of the early 19 70’s were abandoned. Just like any other market, the principle was to allow market forces to dictate market prices, rather than to impose ‘artificial’ pegs, such as the gold standard.

Image result for Choosing Your Currency Pairs: Cross Currency Pairs

Until 2007, this was the case – then came the financial meltdown, and the game changed. No longer were exchange rates left to find their free-market level, but manipulation, both covertly and overtly became the defining standard. And the reasons are very simple – self-preservation, as central banks around the world, battled to maintain their fragile economies, particularly those with strong export markets, and the so-called ‘race to the bottom’ began. This was simply a process of implementing ultra-low interest rates to protect exports. In addition, many banks began printing money (referred to as quantitative easing) by buying bonds, to stimulate inflation in stagnant economies, creating yet another artificial component in the currency markets.

One of the principal exponents of this policy has been the US Federal Reserve, which has systematically continued to print money, ever since, creating a false market for the currency of the first reserve.

This is what I mean when I say a ‘game changer’. The world of foreign exchange has changed, not forever, as ‘normal’ market conditions will return in the next 5 to 10 years, but for the present and foreseeable future, this is a very different market. No longer are interest rates dictated by economic forces, they are dictated by self-preservation. Equally, supply and demand of currencies are no longer left to the market. It is the remit of the central bank to protect the economy – self-preservation again.

In such a world, the cross currency pairs offer an alternative, away from the artificial world of the US dollar. Whilst I would be the first to admit that they have some disadvantages, on balance, these are outweighed by the advantages, even if you are just starting out on your forex trading journey.

Let’s take look at some of the pairs I would suggest as possible starting points, and those to consider as alternatives to the major currency pairs.

EUR/GBP

Image result for Choosing Your Currency Pairs: Cross Currency Pairs

The EUR/GBP is one of the less volatile cross currency pairs and represents the economic dynamic between Europe and the UK. Whilst the euro is politically sensitive as a major, particularly against the US dollar, as a cross pair against the British pound, the characteristics change, with the pair returning to ‘old school’ price behavior based on economic and technical forces. In some respects, the euro adopts the characteristics of the pound, and away from the influence of the US dollar, becomes more measured and predictable as a result. This is not an ‘exciting’ pair to trade, but then trading is about consistency, and not about the adrenaline rush!

This is a nice pair to trade as a novice. The price action is steady, and for intraday medium term trading, there are always plenty of opportunities, particularly based on the fundamental news releases in both Europe and the UK during these trading sessions. The pair does trend longer term, but in recent times has been rangebound so a shorter term or intraday is my suggestion here.

EUR/CHF

This is another pair in the same vein as the EUR/GBP. In this case, it’s the euro matched with the Swiss franc. This is a pair for longer-term trading, as it can become becalmed for long periods of time, and move in a very narrow range. But as always patience is a virtue and for longer-term traders, any breakout from these congestion phases is usually rewarded with a nice trend.

This is an interesting pair for several reasons. First, the Swiss franc has increasingly been seen as a safe haven currency over the last few years. Switzerland is seen as safe in every respect and with a stable economy and renowned banking system underpinned by gold, the Swiss franc has strengthened accordingly. The net result of this has been that the Swiss National Bank has intervened on several occasions to prevent the currency strengthening further, and it does so in the full knowledge of the ECB. The recent flood has been in the 1.2000 regions, but as the financial crisis begins to subside, then we may see the

Swiss franc weakens as money flows out from the pair and back into higher risk assets in due course.

AUD/JPY

Now we move to some of the more volatile currency pairs, and there are several to choose from here, all based on the Japanese yen. The Aussie dollar, however, is always the starting point, as it is an excellent barometer of risk in the currency market. If the AUD/JPY is rising then the Australian dollar is being bought and the Japanese yen is being sold.

This reveals two things. As I mentioned earlier, the Aussie dollar is closely associated with commodities, therefore the currency is a measure of risk buying or selling since commodities are seen as risk assets in general terms. Equally, and on the opposite side of the currency, selling or buying of the yen is also a measure of risk flow. Selling the yen implies investors and speculators ready to take on more risk, both in the carry trade and elsewhere, whilst buying of the yen implies the opposite.

Image result for Choosing Your Currency Pairs: Cross Currency Pairs

The AUD/JPY, therefore, tends to provide a barometer of risk appetite across all the financial markets. As with all these relationships, they can and do change over time, and indeed the Australian dollar is another currency which is seen as a ‘safe haven’ largely as a result of the economic stability of the Australian economy in the last few years. However, this has to be counterbalanced by its close association with commodities and in particular China, and any slowdown in economic growth here will be reflected firmly in the Aussie dollar and the Aussie yen pair.

CAD/JPY

This is an interesting pair as it has a relatively close correlation to the price of oil. Canada is a major exporter, and the Japanese are major importers. If oil prices are rising, at the same time as the yen is being weakened by ‘risk on’ or politics, then the pair will move quickly. The weekly oil inventories release on the economic calendar will also play a part here, with any build in reserves, bad for the price of oil, and any draw, generally good. So, there are several influences, but as always with the yen crosses, if you get the direction right, then your account will start to build very quickly. Conversely, get it wrong and this is where your money management and risk management will really pay dividends.

There are many other cross currency pairs, with a variety of spreads and relationships. The ones I have outlined above are the starting point and some of the more liquid that are traded in this group.