Cross Over to a Better Trade
Two Trillion Dollars Per Day All Going the Same Way
The currency market is the biggest and most liquid financial market in the world, generating over $500 trillion dollars in volume per year. But at its core, foreign exchange (forex or FX) is just a one-trick pony. More than 90 percent of all trades in the market are executed against the U.S. dollar. Therefore, every morning when forex traders log into their Bloomberg terminals from Tokyo to London to New York the only question that races through their minds is: do I love or hate the almighty buck today? On any given day in the forex market, whether you are long the euro/dollar (EUR/USD) or long the pound/dollar (GBP/USD) or long the Aussie/dollar (AUD/USD), the results are likely to be very similar. If the dollar is weak, you will win. If the dollar is strong, you will likely lose money.
Why is this so? Because the dollar is the reserve currency of the world. Almost all of the key agricultural and industrial commodities in the world are priced in U.S. dollars. Not the least of which is oil, considered to be the single most valuable and strategic asset for every advanced and emerging growth nation on the globe. If Australia, a country rich in minerals but poor in oil, needed to purchase crude, it would have to first exchange its currency for U.S. dollars and then use the proceeds of that transaction to procure petroleum. The same goes for China, India and Japan, and other nations of the world. Little wonder then that almost every country’s central bank stockpiles dollars in its reserves. In fact, the Bank of China has been able to inventory almost a trillion U.S. dollars in its foreign reserves. Therefore it is quite understandable that the vast majority of corporate and speculative activity takes place with U.S. dollars as part of the transaction.
However, for traders, this type of order flow doesn’t really provide a plethora of opportunities. After all, stock traders have a universe of more than 5,000 companies to research for trade ideas. The currency market is already limited to only seven liquid pairs to trade — the four majors: EUR/USD, USD/JPY (dollar/yen), GBP/USD, USD/CHF (dollar/Swiss); and the three commodity pairs: AUD/USD, U.S. dollar/Canada (USD/CAD), New Zealand/U.S. dollar (NZD/USD). Every one of those pairs is highly correlated to the fortunes of the dollar.
Cross Over to a Better Way
Is there a more creative way to trade the forex market besides making simple pro- or anti-dollar positions? You bet. In addition to trading the majors or the commodity pairs, traders in the forex market can also trade crosses. Cross pairs are simply currency pairings that do not contain the U.S. dollar as part of the transaction.
Actively Traded Currency Pairs- Euro/Yen (EUR/JPY)
One of the most popular pairings in the world, this currency cross trades off the economic and political differentials between two key regions of the world – Euro-zone and Japan.
- Euro/Sterling (EUR/GBP)
Although the U.K. is part of the European Union (EU), it is not part of the European Monetary Unit, preferring to maintain its own currency the pound. As such the EUR/GBP cross trades off the growth differentials between the EU and U.K.
- Canada/Yen (CAD/JPY)
One of the most active crosses over the past year, it became a very strong proxy on the price of oil. Canada, the world’s second largest owner of oil reserves, benefits tremendously when the price of crude rises. Fully eight percent of the Canadian economy is directly involved in the energy business, and perhaps as much as 35 percent of the economy benefits indirectly from high oil prices. Japan, on the other hand, must import 99.4 percent of its crude demand, as the country has virtually no native reserves of oil. Therefore this cross rises and falls with the price of oil, exhibiting 87 percent correlation with crude in 2005.
- Sterling/Yen (GBP/JPY)
One of the most popular currency crosses employed in the carry trade. [The carry trade is a widely used strategy in the currency market that attempts to profit from the interest rate differentials between currencies.] The British pound has an interest rate of 4.50 percent, while in Japan, as a result of 60 consecutive months of deflation, the short-term rates have declined to zero percent. Therefore, traders who went long the GBP/JPY cross and exchanged pounds for yen would stand to make 4.5 percent on an annual basis, even if the cross did not appreciate a single point! If traders used 10:1 leverage the returns would become 45 percent per year. Not too bad for just collecting interest. Of course, if the position went against the trader at 10:1 leverage, the losses would magnify quickly and the benefits of high yield would offer little protection to the trader. Nevertheless, the GBP/JPY cross is actively traded, especially by Japanese investors seeking to capture the rich U.K. yields in the absence of fixed income returns at home.
- Euro/Swiss (EUR/CHF)
One of the least volatile crosses in the world of FX, this pair trades off the growth rate differentials of Switzerland and its much larger next door neighbor: the Euro-zone. The Swiss franc is also known as a traditional store of safe haven capital in the currency market, therefore whenever the world is embroiled in geo-political turmoil or terrorist threats, the EUR/CHF pair declines in value as investors flock to Swiss francs - selling euros in the process.
Key Factors that Move Crosses
Crosses are fascinating instruments to trade because they allow the trader to make directional bets without having to take into account the movements of the dollar. Let’s suppose that the U.K. reports particularly positive economic news, and that leads the market to revalue the country’s growth potential in the upcoming year. A trader who decided to go long the GBP/USD could not be at all confident that his position would pay off. If at the same time the U.S. came out with similarly positive news, the GBP/USD might actually decline in value, as U.S. positive surprises would trump the U.K.’s strong fundamental news. Because the U.S. is the largest economy in the world, U.S. news – both positive and negative - tends to have the greatest impact on the currency market. On the other hand, a trader who bought the GBP/JPY pair may have a greater chance of success as the pound (given the positive fundamentals of our example) may decline far less against the dollar than the yen, in turn producing a gain in the GBP/JPY cross.
In general, crosses trade off three key factors: growth rate differentials between countries, interest rate differentials between countries, and cross border merger and acquisition activity. Of the three, the last factor tends to have the least amount of lasting impact but can create serious skews on a day-to-day basis. Therefore, it is imperative that currency traders keep a sharp eye on the stock markets of the respective currencies. If, for example, a U.K. corporation announces a multibillion-dollar bid for its European competitor, then the potential for the EUR/GBP cross to rise during the day is quite high. On a longer-term basis however, growth rate differentials and interest rate spreads determine the vast majority of cross currency movements. The rule of thumb in FX is this: the larger the interest rate spread, the more volatile the pair. Note in Table 1 how cross pairs with the largest interest rate differential over the past two months (as of late January) also have the widest trading ranges. Indeed, as interest rates between currencies expand so does their range. This happens because the wider interest rate spread attracts carry trade speculators, all of whom tend to plow into and out of the trade all at once, creating massive volatility in the process.
Politics: The Final Dimension
Because currencies represent countries as well as economies, they are one of the few financial assets that are highly responsive to political as well as economic news. Savvy traders who can accurately analyze the political landscape can profit tremendously from such trades. In 2005, the biggest such opportunity came after the collapse of the EU constitution. By voting no in May of that year, voters in France derailed the passage of the EU constitution, which required unanimous ratification from its member states. A week later, voters in the Netherlands did the same. The European Union was thrown into turmoil as fears spread that the Union and even the euro itself would break up and disappear. See Figure 1 to find out how the EUR/CHF cross responded. The pair dropped 200 points as investors liquidated euros and bought the Swiss franc in a massive flight to safety
The political trade was on display again in September of 2005 when both Germany and Japan held their national elections at approximately the same time. In Japan, the LDP party, led by its reform-minded Prime Minister Junichiro Kouizumi, was well on its way to an overwhelming election victory. Meanwhile in Germany the outcome was far less clear, as the CDU leader Angela Merkel managed to squander an early lead against her socialist opponent, the incumbent Gerhard Schroeder. (Ultimately she won the election and became the first woman chancellor of Germany.) Traders who seized on this disparity profited handsomely by essentially playing the “Kouizumi/Schroeder spread” by selling the EUR/JPY cross as the Japanese political landscape appeared to be far more favorable than the European one. Figure 2 shows the extent of the move as election news was being reported from the opposite sides of the globe.
Be Creative
The crosses discussed in this article are available on virtually every retail FX platform. However, if a trader wanted to trade more unusual positions he or she might have to construct the cross synthetically. A synthetic cross is simply the act of combining two common pairs to create a cross position. Suppose you believed that gold was inexpensive relative to oil and wanted to express that opinion in the currency market. One way to do it would be to go long the AUD/USD pair (Australia is the world’s second largest exporter of gold and the Aussie is highly sensitive to the price of precious metals), while at the same time selling Canadian dollars against it. The Canadian dollar has become a petro-currency and therefore the closest proxy to the price of oil in FX. To do that a trader would go long USD/CAD (remember that in the case of USD/CAD the order of currencies is reversed so to achieve a short CAD position one would actually have to go long USD/CAD). In the end he would have two positions on the books – long AUD/USD and long USD/CAD. Then a trader will have achieved a synthetic long AUD/CAD position. Thus for those retail trading platforms that do not carry the AUD/CAD cross natively traders could still create the trade synthetically.
Take the Path Less Traveled
Regardless of how you choose to trade them, crosses represent an unexplored opportunity for most retail FX traders. Getting to know these currency pairings could result in many more trading opportunities for savvy retail traders willing to choose a less traveled path.
Date: March 2006
