Over the last month, we have seen a significant sell-off in global equity markets in response to concerns around the Chinese stock market crash, and the possibility of a rate rise in the US.
This volatility in the stock markets transfers across into the currency market, presenting traders with plenty of trading opportunities.
But what currencies should you be trading?
Here are a few that you might want to keep your eye on.
The premier funding currency: JPY
When times are good, investors purchase high yielding currencies and fund the trade with a low yielding currency.
This is commonly known as a “carry trade”. With its perennially low interest rates, the JPY is the premier currency used in this transaction, i.e. the funding currency.
When stock markets get the jitters, we typically see these trades unwind.
The carry trades tend to be utilised when there is low market volatility. When the volatility starts to increase markedly, these trades need to be exited – hence the unwind. The models all flip out of low volatility carry trade regimes into higher volatility strategies.
This means investors rush to buy back their yen positions, strengthening the currency. This is exacerbated by the fact that traders know that the yen is a funding currency. They will buy the JPY just to ride along with the flow.
Classic risk-off: commodity currencies
Conversely, the classic risk-off currency pairs are AUD, NZD and CAD. These are the high yielding pairs that are most often on the opposite side of the carry trade for the funding currencies.
When markets sell-off, these pairs tend to be the first that get hit. In particular, AUDJPY can be used as a proxy for the stock market. It can be sold when stocks fall and brought when stocks recover.
At the moment, AUD and NZD are faced with the additional headwind of being in an easing cycle (i.e. rates are being cut), while CAD is pressured from the falling oil price.
Flight to liquidity: USD
When stocks and other assets sell-off, investors seek the safety of liquidity. And (generally speaking) the most liquid currency in the world is the US Dollar.
This means that when markets crash the USD typically strengthens. Note that this is not true across all pairs. The USDJPY will typically weaken, as it’s on the wrong side of a funding currency trade.
The other factor at play here is that the Federal Reverse Bank is in a tightening cycle (looking at raising rates), which is positive for the currency.
Safe Haven Switzerland: CHF
The Swiss Franc is used as a safe haven during times of turmoil.
The legendary strength of the Swiss banking system, alongside its neutral status, means that investors see the CHF as a safe place to park their money during turbulence.
Additionally, with its current negative interest rate cycle, the CHF is used as a funding currency, meaning investors need to buy the currency to close out their carry trades.
On the flip side of the coin, the Swiss National Bank is doing everything it can to keep the currency weak. An overly strong CHF is harmful to the economy. If the currency strengthens too much, you might find yourself on the wrong side of some central bank intervention.
EUR: The new black?
A feature of the recent market correction was a robust EUR. In particular the EURUSD, which typically weakens during market panics, rose 700 pips in four days.
Does this mean the EUR is now the go to currency when the market crashes?
Possibly not.
While the low interest rates have made the EUR something of a funding currency, the recent move was driven by something different.
Investors had been purchasing European stocks on the thesis they would rise under a regime of quantitative easing. When doing this, they were hedging their currency risk by selling EURUSD.
As the stock positions were exited, the investors had no further use for the hedge, so had to buy back their EURUSD positions. This saw the currency pair rise dramatically.
Will this type of thing happen again?
It well may, but be careful in presupposing the relationship will hold up… particularly if the next market crash puts pressure on the European banking system.
A final word of warning
When I was in the army they used to say assumptions are the mother of all F***-ups.
Don’t assume that currencies will always act the way they should. The environment is very different now than it was in 2008, and we may not see the same relationships between currencies as we have in the past.
So, as always, trade what’s in front of you, and notice if things are different than what you expect.
About the Author
Sam Eder is a currency trader and author of the Definitive Guide to Developing a Winning Forex Trading System and the Advanced Forex Course for Smart Traders (get free access). He is the owner of www.fxrenew.com a provider of Forex signals from ex-bank and hedge fund traders (get a free trial). If you like Sam’s writing you can subscribe to his newsletter.
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