The forex market is heating up

The current fluctuations in the currency market are piquing interest from traders. We provide an overview of the main investment strategies.

By Julie Zaugg

An uncertain climate

According to all the experts, one trend dominates the currency market: the strong dollar. Patrick Reid,  the co-founder of The Adamis Principle, a UK consulting firm that specialises in Forex, believes it is an effect of the US central bank’s (the Fed) policies. "The Fed increased its interest rates more quickly and more aggressively than its counterparts in other countries," he says. As a refuge currency, the dollar is attractive to investors in uncertain global situations.

Valued for its stability, the Swiss franc is in a similar situation. But Switzerland could suffer from energy shortages this winter as a result of the war in Ukraine, which could have an impact on its currency, according to Christopher Lewis, an analyst at the platform Daily Forex. The situation is bleaker on the rest of the European continent. In late September, the pound reached a historic new low, trading at 1.035 against the dollar. The markets reacted to a series of tax cuts announced by the government. "The concern now is that inflation could increase and lead the country into a recession that could last at least five quarters," says Reid.

While the euro is doing marginally better than the pound, it has nevertheless dropped below parity with the dollar, after falling nearly 10% since this spring. "The European Central Bank waited too long to raise its interest rates and the continent will suffer from a shortage of Russian gas this winter," says Reid.

Betting on the strength of the dollar

Peter Trager, an expert on the currency market who teaches at the University of Kentucky, advises investors to bet on the strength of the US dollar. "I would take a long position (ed. note: a buying position) on the dollar, compared to most other currencies," he says.  "I would also take a long position on the euro compared to the pound, because I believe that the problems in the UK seem more serious and more long-term than those faced by the European Union."

This strategy, considered the most basic, is called "momentum". It involves observing the dominant Forex trends and following the movement by taking positions that reflect what other investors are doing. “This strategy can generate significant returns, without taking too much of a risk, because you can quickly sell a position if you feel that the tides are changing,” says Richard Levich, professor of finance at the New York University Stern School of Business. As this strategy requires significant responsiveness, it is best suited to short-term investments. In some cases, positions are bought and sold in the same day – known as day trading.

Remain in the know

To anticipate trends on the currency market, it is crucial to closely follow monetary policy announcements from central banks. A hike in interest rates that is seen as too much, or not enough, could have an immediate impact on a currency. And in some cases, the fact that a central bank abstains from or stops intervening can also be very consequential: "When the SNB discontinued the minimum exchange rate of 1 euro for 1.20 francs in January 2015, the effects were devastating," says Trager. When the limit was removed, the euro briefly fell to 0.965 compared to the franc. 

Currencies are also very sensitive to political decisions, such as the tax cuts recently announced by the UK government, as well as geopolitical turbulence, such as the war in Ukraine. They also react to macroeconomic indicators, such as inflation, growth rate and balance of payments. The weak euro is due in part to the negative balance of payments by the European Union, caused by increased prices for energy imports.

The price of certain currencies is influenced by unique factors. It is therefore worth studying the political and economic situation of a country before investing in its currency. For example, the Canadian dollar is strongly correlated to the price of oil, given that the country is a large oil producer.

Find the currencies that are falsely valued

A second strategy, known as “value”, involves taking a short position on currencies that seem to be overvalued and taking a long position on undervalued currencies, in the hopes that they reach the correct value. “It’s a long-term strategy that requires in-depth knowledge of the currency market,” says Levich. The dollar will most likely remain strong over the next few months, but it can’t maintain its current value forever. “At the first sign of a drop, it will make sense to take a short position on the dollar,” says Reid of UK consulting firm, The Adamis Principle. A report from the International Monetary Fund (IMF) published in August indicated that the US dollar is already overvalued by 20%.

The Chinese yuan, the Czech  koruna and the Indian rupee are also overvalued, according to Bloom berg (at the end of September). Conversely, the Turkish lira, undermined by the country’s rapid inflation and the unorthodox monetary policy of  President Recep Tayyip  Erdoğan, is undervalued, just like the yen.

To determine whether a currency is under- or overvalued, the best method is to conduct the purchasing power parity test, which consists of comparing its exchange rate based on whether the price of a basket of goods in one currency is equal to the price in another currency. There are also a myriad of technical tools, such as the Bollinger bands or the Relative Strength Index, which determine whether a currency is under- or overvalued. The IMF also publishes regular analyses that include  this information.

The interest rate game

A third strategy, known as "carry" involves betting on the difference in interest rates between two currencies. Investors purchase the currency with the highest interest rate using a loan taken out in the currency with the lower rate. Profits come from the difference between these two rates. Rendered virtually obsolete by a long period of interest rates close to zero, the carry strategy has regained popularity thanks to higher interest rates from several central banks.

In the current climate, the USD/JPY pair is particularly well-suited to this strategy. "Using a 10 year bond yield as an example, there’s a differential of approximately 3.5% between the interest rates of these two currencies," says Levich. "That results in a sizeable profit." 

The carry strategy is reserved for experienced investors, as it can lead to many regular small gains, but it comes at a higher risk. "You’re betting on the fact that the currency with the higher rate will continue to increase and the currency with the lower rate will fall, but if the opposite happens, your gains will quickly disappear," says the finance professor. It also requires patience, as changes in interest rates happen over months rather than over several days or hours.

To implement such a strategy, investors need to closely monitor the differences in interest rates between currencies. The CME FedWatch tool, which makes predictions on future announcements from the US federal bank, can be useful in this approach.