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By Sheldon Slabbert, CMC Markets
When investors decide to move into cash, the key question is, what currencies should they hold it in?
For Kiwis, the New Zealand dollar has been a reasonable store of value. But over the years, it has gone through periods of significant underperformance and volatility. Allocating some money to a different currency or ‘basket’ of currencies could provide protection and might increase your overall returns.
Let’s look at gold. It’s seen as the currency with the best record as a store of value. So some investors choose to have money allocated to gold, to protect the purchasing power of their currency.
The currency markets also offer investors speculative opportunities. The recent sharp move in the British pound, sparked by Brexit, has propelled the New Zealand dollar to 30-year highs (see Figure 1). Our dollar is also trading at near all-time highs against the Canadian dollar and the euro. And many investors have capitalised over the years on the near-attempts of the New Zealand dollar to reach parity with the Australian dollar (see Figure 2).
How to invest in currency markets
The currency markets are the world’s largest and most liquid, with a daily volume of more than US$5.1 trillion dollars, according to a 2016 Bank of International Settlements (BIS) survey. Eighty-eight per cent of all transactions include the US dollar, the BIS survey showed.
Over the past 10 years, we have seen a growing number of New Zealanders trading in the money markets, and they are no longer the sole domain of banks and large financial institutions. You don’t have to be a George Soros or Bill Lipschutz to navigate the currency markets. Many successful individual traders and investors apply very similar methods to analyse currency to those they use with shares or real estate.
The exchange rates of currencies are largely influenced by the economic performance of a country, along with its level of political stability. In turn, the interest rates of a country have become increasingly important, as investors seek better yields in a low-return investment environment.
Many investors take advantage of the difference in interest rates in two countries, by selling the lower-yielding currency in favour of a higher-yielding currency and profiting from the difference in interest rates as well as the currency appreciation. This is called a ‘carry trade’.
The New Zealand dollar has long been a favourite for these types of trades. An example is the New Zealand dollar against the Japanese yen. The yen is referred to as the ‘funder’, and the New Zealand dollar the ‘yielder’, as the country having the higher rate of interest.
The New Zealand dollar also attracts flows due to our agricultural economy. Currencies anchored by commodities such as agriculture, energy, or metals are referred to as ‘hard’ currencies. Other examples of hard currencies are the Norwegian krone, Australian and Canadian dollars, and Russian rouble. Currency dealers often like to trade hard currencies against currencies that are more financially based, such as the yen, euro and British pound.
Investors further break down the currencies they will trade in by economy size. For example, they may look to only invest within the relative stability offered by the G10 currencies. Others, with a higher risk appetite, may prefer the currencies of emerging markets and the BRICS countries.
Should investors not wish to do the trading themselves, many investment funds and exchange traded funds (ETFs) specialise in currencies. These funds often focus on specific areas and economic themes, and they offer alternatives to simply buying or selling a single currency pair.
The risks of investing in currency
The perceived volatility in currency markets is real, but not as extreme as many people think. Headline-grabbing events, like the recent Brexit and American vote, help to reinforce a perception of excessive volatility in the currency market, but such circumstances are rare. The probability of a currency dropping to zero value and ending up worthless, as we have seen with the Zimbabwean dollar, is a lot less likely than that of a stock (as was the case with Bear Stearns or Dick Smiths).
Leverage can be a double-edged sword and many misadventures in the currency markets are due to the misuse of leverage.
Just like buying equities or property, there are transaction costs to consider when trading currencies. Technology and competition have seen transaction costs reduce considerably, making currency markets more accessible. But costs can differ materially among banks and brokers, and it pays to do some homework.
Outlook for key currency markets
The New Zealand dollar is the 11th most-traded currency in the world, representing 2.1 per cent of global transactions. We expect our currency to remain among the top-traded currencies – if our economy continues to perform well and our interest rates remain attractive.
The Chinese renminbi has continually grown its share of the global currency markets, and that trend may only be in its infancy. The currencies of other BRICS nations and countries in the Asia-Pacific region are also expected to grow in value over time, as their trade increases relative to global GDP.
Investors will also keep an eye on the US Federal Reserve, and its attempts at normalising interest rates. The pace and direction of future interest rates in the US could greatly influence the value of their dollar.
Events such as the Brexit and American vote are creating opportunities, as markets often ‘overshoot’ after a scare, and then revert. And further down the track, some Eurosceptics are questioning the long-term viability of the single currency.
BRICs: The four most important emerging markets, namely Brazil, Russia, India, and China. The final ‘s’ is sometimes capitalised to represent South Africa.
EXCHANGE TRADED FUNDS (ETFs): An investment fund traded on stock exchanges, similar to a form of index fund. A ETF tracks an index, commodity, or a basket of assets.
G10 CURRENCIES: United States dollar, euro, Japanese yen, British pound, Swiss franc, Australian dollar, New Zealand dollar, Canadian dollar, Swedish krona, and the Norwegian krone.
GDP: Gross Domestic Product is the monetary value of all the finished goods and services produced normally within a country’s border and in a specific time.
LEVERAGE: The use of borrowed capital to fund an investment.
STORE OF VALUE: An asset that can be kept, then retrieved and traded in the future, holding its value over time.