The largest – and wildest – market in the world is also one of the least reported on. While stocks and bonds garner most of the press and investor attention, currency markets are where the real money is.
Approximately $4-trillion sloshes around the globe each day as participants pit currencies against each other. Traditionally, banks, hedge funds and major companies dominated the foreign currency markets, or FX. But with the rise of the Internet, retail investors can speculate on equal standing with the largest banks.
Besides its massive scale and the fact that currency markets never close, what sets FX trading apart is that there is little regulation and no formal exchange structures like the Toronto or New York stock exchanges. FX participants trade with one another on agreed-upon credit terms. Currencies do not necessarily move from country to country or bank to bank because most trades are speculative; when they are settled, the currency speculated on stays put.
Retail investors are often drawn to FX because of the excitement that comes with a market that never sleeps and the fact that they can use hefty leverage to turn small bets into major gains (or losses). A trader with a margin ratio of 5 per cent, for example, could speculate on $100,000 worth of currency with just $5,000 of his or her own money.
In Canada, the majority of the FX trade flows north and south, dominated by companies needing to buy and sell greenbacks or loonies with the flow of goods.
“For us, because there is a business requirement behind it, I would say 90 per cent of what we do is U.S.-Canada, either buying or selling, and the other 5 per cent is the euro and the pound,” says Rahim Madhavji, president and head trader of Knightsbridge Foreign Exchange of Toronto, which buys currencies for companies and investors.
Experienced traders know what factors will drive a particular currency: Canada’s dollar, for example, is highly correlated to commodity prices and the health of the global economy, so economic growth in places such as China and the U.S. are important underpinnings for it.
The loonie also owes much of its recent strength to the maintenance of a higher central bank interest rate than in the U.S., where the Federal Reserve is pursuing an ultra-low-rate policy in an effort to kick start its moribund economy.
“Interest rates are a big driver, and the reason is a lot of global players and countries and sovereign wealth funds like to park their profits [or holdings]in currencies that pay a yield,” says Mr. Madhavji. “So they will put in a very short term GIC, for example, and Canada just pays more than the U.S., so what a lot of people are doing is moving toward currencies that pay a higher yield.”
That yield differential is a major reason behind the recent run of the Australian dollar, where investors can earn a 4 per cent yield compared with less than 1 per cent in the U.S. Australia, which like Canada has an economy that is highly dependent on commodities, has to pay more in interest in part because its currency represents a riskier, more speculative bet.
Despite its well-publicized problems, the U.S. is seen as a safe haven by investors while Canada and Australia are seen as nice places to park money. “In the short term, the loonie is a risk currency and the U.S. dollar is a safe haven currency,” says Mr. Madhavji.
Even though the Canadian economy is stronger than that of the U.S. by most measures, it takes good economic news to raise the loonie’s fortunes, while discouraging economic indicators will likely hurt the loonie and lift the U.S. dollar. “If the stock market goes up, if oil prices go up, if the U.S. or Canadian economies go up, the loonie will go up.” The correlation between good/bad news and the loonie’s value are between 60 per cent and 80 per cent, says Mr. Madhavji.
The most striking example occurred with the 2008 collapse of investment bank Lehman Bros., which resulted in a 20 per cent spike in the value of the U.S. dollar. Investors flocked to the greenback even though it was a made-in-America crisis that would be the catalyst for an international financial meltdown and recession in the developed world.
Currency traders are always on the watch for the next Lehman-like event, whether it’s a Greek debt default, a double-dip recession in the U.S. or a hard landing in China after years of double-digit growth.
For months, traders’ attention has been focused on Greece, which, though it’s a tiny piece of the Euro zone, could spark a breakup of the world’s largest economic region and another international financial crisis if its debt problems are not dealt with.
Complexity comes with the territory for currency traders.
“Just like any other asset class it requires a good deal of research and market understanding to actually participate in certainly the most liquid asset class that is out there,” says Dean Popplewell, a currency analyst with Oanda Corp. who writes a daily note that these days has a decidedly Europe-first focus. “Anybody who trades foreign exchange, it is a combination of obviously fundamental and technical analysis.”
He likens his job to trying to put together a global jigsaw puzzle whose pieces – Europe, China, Australasia and North America – vary in size and importance on a daily basis. “It’s putting everything together and understanding the big picture before anyone makes a calculated bet on a currency.”
Canada’s Goldilocks status as a second-tier “proxy reserve currency” bears watching, says Mr. Popplewell. “Canada has been the darling, but recent concerns have been exposed and transparently been communicated by our [Bank of Canada Governor Mark]Carney in the last little while.”