With almost 200 countries and independent states in the world, each with their own currency, deciding on which currencies to trade and when can be a daunting task. In fact, the problem is far worse than this, since, in forex trading, each currency is then quoted against another, resulting in literally thousands of currency pairs covering all the possible combinations.
But don’t worry. Help is at hand, and in this chapter, we are going to focus on those currencies and currency pairs, which are the bedrock of the forex market.
Now at this point, I feel it is both appropriate and relevant to explain how the forex market has changed over the last few years. The catalyst for this was the financial turmoil, triggered in 2007 by the subprime mortgage crisis which sent world economies into a steep decline, and ultimately deep recession. Banks such as Lehman Brothers and Bear Sterns collapsed, as the true extent of the crisis, unfolded. In Europe, the situation was so severe that several countries came close to bankruptcy, only saved by the intervention of the European Central Bank.
What effect has all this had on the currency markets?
The simple answer is dramatic. This is not the book where I propose to cover this in detail. I have written other books on this subject, but I wanted to touch on it here, and the main drivers of change have been the central banks of the United States, Europe, Japan and other major economies around the world. What each of these has done in different ways, is to distort the currency markets, by effectively printing money using a process referred to as quantitative easing. You can think of this as increasing the amount of currency in the market, which helps to drive some much-needed inflation into ailing economies. It is a blunt instrument at best, with indeterminate results.
Secondly, the banks have been forced to lower interest rates too low, or ultra-low levels, in an attempt to stimulate growth in otherwise stagnant economies. This has led to what has been dubbed the ‘race to the bottom’. In other words, each country’s central bank deliberately attempting to maintain a low-interest rate, which in turn helps to protect its export market. This is particularly true of major exporters such as the US, Japan, and China. This sequence of events has distorted what was once a system of ‘free floating’ exchange rates and is a feature which is set to continue for years to come. It is a fact of life and one we have to live with as traders.
There is nothing we can do about the situation, except to recognize the fact that the foreign exchange markets have been drastically distorted by the events of the last few years. They will return to ‘normal’ within the next five to ten years, as the effects of the financial crisis start to wane, but for the time being, this is the situation and one that we have to accept. If you were starting your trading journey in the forex market ten years ago, then life would have been very different. I am not suggesting that it was ever easy, far from it, but the word I would use here would be ‘predictable’.
The financial crisis has removed that ‘predictability’ from the currency market in many different ways, and not least in the various attempts by central banks to both protect, and stimulate their own economies. This is what I meant in the last chapter when I referred to the paradox of the forex market. On the one hand, it is global, and yet on another, it is very local. Central banks will do anything and everything in their power to protect their own economy first. It is very much a case of ‘I’m all right Jack’. We see this every day, and interest rates and quantitative easing are all part of this distortion. Add in the politics of Europe and the major economies of the world, and it becomes a witch’s brew. Even the fundamental news has lost that predictable element.
And it’s not just in the currency markets themselves that these changes are having an effect. The bond markets have been the vehicle used by the central banks for currency creation, as they buy bonds in ever increasing quantities. At some point, this will cease, but as this is ‘new territory’ for the central banks, no one knows what the long-term effects will be, once these programs are tapered and cease. Least of all the banks themselves. All of this will play out in the next few years in the currency markets, and as forex traders, we have to be aware of these forces. The ‘predictability aspect’ of trading in currencies has gone. It will return, but not for many years, which is why volume becomes a key tool in our trading armory. It is one of the few indicators, which when combined with price, truly reveals what is happening as a currency moves higher or lower. Volume and price reveal the truth behind the move, which is why it is so powerful, and perhaps even more relevant today than ever before.
The above comments are not designed to frighten or worry you, they are simply a statement of fact. Things have changed and I would be doing you a huge disservice if I did not make this clear from the start. It’s something to be aware of, and accept, and as you will see later, these changes have also led to changes in the focus on which currency pairs to trade.