In last week’s MarketPulse article we introduced the concept of Foreign Exchange (FX) trading and a few of the significant advantages associated with this rapidly growing sector of the markets. This week we’ll continue on with the discussion and discuss some of the factors driving FX markets with special attention on the outstanding performance of the Australian Dollar.
To recap, FX trading simply involves the exchange of one country’s currency for another. FX is quoted in ‘pairs’ of currencies, that is, how expensive one currency is in terms of another. Much like you would say that an avocado costs $0.99 Australian dollars; we would say that one Australian Dollar (AUD) costs $0.9900 US dollars (USD). In the same way that A$0.99 buys you one avocado, we could equally say that one avocado buys you A$0.99 (hard to imagine people exchanging avocadoes for cash – however, imagine you were returning one you purchased and just changed your mind on to Coles. Your avocado would indeed fetch A$0.99). In the AUDUSD example all we are saying is that one AUD will buy US$0.99 and US$0.99 will buy you A$1.
The more AUD an avocado fetches (say $2.99), the more expensive we say an avocado is, or that it has appreciated in value. Likewise, the greater the cost of one AUD in terms of USD (say $1.01), the more expensive we say the AUD has become versus the USD, or that it has appreciated against the USD. If the AUD becomes cheaper versus the USD (say $0.8000), we say it has depreciated against the USD.
Avocadoes or Yen?
There are five ‘major’ currency pairs, and countless ‘exotic’ or ‘minor’ currency pairs. Many FX traders focus only on trading the majors, and these are:
– The European Euro versus the United States Dollar (EURUSD), more commonly known as “The Euro”;
– The European Euro versus the Japanese Yen (EURJPY), more commonly known as “The Euro-Yen”;
– The Great British Pound (Sterling) versus the United States Dollar (GBPUSD), more commonly known as “The Cable”;
– The United States Dollar versus the Japanese Yen (USDJPY), more commonly known as the “Dollar-yen” or simply “The Yen”;
– The United States Dollar versus the Swiss Franc, (USDCHF), more commonly known as “The Dollar-Swiss”, or simply the “Swiss”, “Swissy” or “Chief”.
Until recently, our own Australian Dollar versus the United States Dollar (AUDUSD or “The Aussie”) was considered a minor currency pair. Over the last few years however, its popularity amongst global investors has spiked due to our economy’s large exposure to China and other emerging markets in Asia. As a result, the amount of AUD traded, especially against the USD in which many bulk commodities (nickel, copper, coal and iron) are traded in, has soared.
According to the Bank of International Settlements (BIS), the rise and rise of the Australian dollar as a world standard currency means that it is now the fifth most traded currency pair in the world. This is an astonishing achievement when one considers the size of Australia’s population, and its relatively small economy on a world scale.
The Lucky Country
As you are probably aware, the AUDUSD exchange rate has risen strongly since the depths of the Global Financial Crisis (GFC) from around US60 cents per A$1 to roughly parity (US$1 to A$1). This means that if you were to have travelled to New York when the GFC was at its worst, you would have only received US$60 for every A$100 you exchanged. Today, you would receive approximately A$100 – a major improvement in the value of the AUD versus the USD and a whole lot more shopping at Bloomingdales!
There are a number of other reasons apart from the Aussie Dollar’s exposure to the Chinese economy which can help explain its amazing appreciation against the USD. A country’s currency will tend to appreciate against others if the rate of interest paid within that country is superior, on an inflation-adjusted basis, compared to other countries.
Since the GFC, Australia’s economy has remained far more robust than its American counterpart, both in terms of economic growth as measured by Gross Domestic Product (GDP), and unemployment as measured by the unemployment rate. Each has significantly outperformed corresponding US measures of growth and unemployment.
The result is that interest rates in Australia have remained very high compared to those in the US. Further, as inflation in each country has been equally subdued, returns on safe Australian interest paying assets like Australian Government Bonds are far more attractive than those achievable on US equivalents.
The final factor in the Aussie Dollar’s spectacular rise is a massive ‘terms of trade’ boom. This simply means that Australia is getting far more foreign currency for the goods and services it exports than it pays for the goods and services it imports from the rest of the world. You don’t have to be a rocket scientist to figure this one out…as the ‘Lucky Country’, we have buried in the ground all of the good stuff the rest of the world wants! In combination with the other factors discussed above, there has been a veritable flood of US Dollars to purchase Australian Dollars forcing the AUDUSD higher.
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The big question of course is whether the AUD can keep rising, will it stagnate around parity, or potentially even fall back to more historically familiar levels around US80 cents. Note though that for many FX traders, such bigger picture questions are merely a distraction from the day to day ebb and flow of the FX markets.
You see, most retail FX traders, including small private traders potentially even like you, tend to be very short term in nature preferring to ‘scalp’ small fluctuations in various exchange rates. They can afford to do so because of the tremendous leverage afforded to FX traders. Leverage simply means putting up a small amount of money to take a bigger position in the market.
As we discussed last week, FX is traded in very small price increment points called ‘pips’. A one pip move in the AUDUSD, for example, is 0.0001 of one dollar (imagine the AUDUSD going from 0.9951 to 0.9952).
Typically, an FX trader will aim to make a few hundred pips a week. Depending on the size of the account they have, and the size of the contracts they are trading, this could be as little as a few hundred dollars a week, to a few thousand. Certainly, for many FX traders, trading is a constant and exciting battle of wits with the markets.
We’ll pause there for now and pick up our discussion on FX trading next week and ponder why it is the fastest growing source of enquiry from Australian Stock Report members.