In the world of currency trading, an essential fact is frequently overlooked, which is that foreign exchange rates are reference numbers, not expressions of immutable values. Put more simply, one currency is priced against one or more other currencies, and those prices change all the time.
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Because of this, currency trading is what is known as a zero-sum game, in which a rise for one currency must mean a fall for another. Yet even seasoned observers of the foreign exchanges – traders, commentators, even economists – talk in terms of “dollar strength”, “euro weakness”, or the other way around.
There are occasions when traders should explore the reasons why, for example, sterling is falling against the yen, but they ought never to forget that, in such a case, sterling “weakness” is another way of talking about yen “strength”.
The middle currency
Following on from this, it is impossible in almost all cases for all currencies to rise or fall at the same time. There is one exception to this, and we’ll examine it in a moment.
First, the pricing of one currency against another gives rise to currency “pairs”, such as sterling/dollar, Swiss franc/euro or yen/dollar. Most major currencies are quoted against other major currencies in what are known as “cross rates”.
A cross-rate is a direct quote of the value of one denomination against another. By contrast, the world’s lesser currencies, such as those of many developing countries, do not have cross rates. They are quoted in US dollars only.
Someone wishing to exchange such a currency for, to take an example, sterling would first switch the currency into dollars and then out of dollars into sterling, the dollar acting as the middle currency in the transaction.
So, currency pairs are created by cross-rates, giving rise to the question of which pair is right for the novice currency trader. Which is the best currency pair to trade?
There is no “correct” answer to the question of the best forex pair to trade, and the decision as to which pair to trade will depend largely on the temperament of the trader in question.
They may, for example, chose the dollar/euro pair, one of the most, if not the most, heavily-traded pair in the world. During the last 12 months, the dollar’s value against the euro has fluctuated within a fairly narrow range.
It began the period at €0.8167 and is currently about €0.8810, a movement of just over six euro-cents. During the year it saw a low of €0.8033 on 26 March 2018 and a high of €0.8915 on 12 November, a trading range of nearly nine euro-cents, or about 11% of the rate at which the period began.
An “exorbitant privilege”
Whether you find that range somewhat daunting or rather dull is, again, a matter of temperament. But there are matters of fact that can inform the trader’s thinking on this particular currency pair.
One is that at no time during the past five years has the dollar achieved parity with the euro. The latter has always been the “heavier” currency.
Another is that the sheer size of the US and euro-zone economies steadies the exchange rate and makes less likely that they will experience big swings against each other.
A third is that this economic heft means both currencies are likely to enjoy a bedrock of demand simply because consumers round the world will want to buy the goods and services priced in these currencies.
And a fourth is that the dollar enjoys an advantage over the euro in that it is the world’s premier reserve currency, almost an auxillary global denomination. This greatly bolsters demand which, in turn, leads to what former French President Giscard d’Estaing once called the “exorbitant privilege” of America being able to run huge trade deficits.
Back to that 11% trading range, and contrast it with the performance of sterling against the dollar in the years since the 2008 economic crisis. As the boom ended, the pound lost about a quarter of its value, from $2 to $1.75. Following the Brexit vote in June 2016, it plunged to just over $1.20, a 40% loss of value in total.
Does the relative stability of the dollar/euro rate make it unsuitable for trading? By no means. It is precisely such relative predictability that creates the opportunity for “swing trading”, riding the exchange rate on the ups and on the downs.
Similarities - and differences
Someone seeking a rather less predictable forex pair to trade may trade a more obscure currency pair, such as sterling and the Turkish lira. During the last 12 months, the rate has oscillated from 5.51 lira on 20 March last year, a 12-monthly low, to a high of 8.87 on 13 August, a trough to peak range of more than 60%.
A pound currently buys 7.21 lira.
Anyone fancying a swim in this pool needs to do some homework on the factors that drive trade and financial flows between these two very different countries.
One is that they enjoy good relations, are both members of the North Atlantic Treaty Organisation (NATO), and have strong trade links, with British-based companies including BP, Vodafone and Tesco operating in Turkey. Big Turkish exports to the UK include textiles, clothing, cables and iron and steel, while Britain sells Turkey, among other things, engines, cars and medicinal and pharmaceutical products.
To mention just three differences, there are 65 million people living in the UK against 81.3 million in Turkey, Britain is ranked 39thin the world for economic output per head, while Turkey stands at 77th, and Britain’s is one of the most stable democracies in the world while Turkey’s leaders are accused of authoritarianism and the country suffered a coup attempt in 2016.
Finally, we noted earlier that there is one exception to the rule that currencies cannot all rise and fall against a monetary unit at the same time. The exception, of course, is gold.
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