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How to Profit From the Global Currency War

Currencies / Forex Trading Oct 05, 2010 - 06:45 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleJack Barnes writes: If you’re like me, and you spend a lot of time perusing financial Web sites in search of the latest global investing news, you’ve probably started to see a lot of stories about rapid shifts in foreign exchange rates – including some “currency pairs” that have traditionally been rather slow-moving.

Back during the spring, for instance, the news was full of stories about how Switzerland was buying up European euros in an effort to weaken the strong Swiss franc – only to have that country change course and diversify its holdings by purchasing U.S. dollars.

During the summer, we watched as Japan entered the foreign exchange (or “FX”) markets for the first time in nearly a decade in order to buy U.S. dollars.

Even South Korea has been a contestant in the currency-transaction arena, with that Asian tiger working to weaken its currency, the won, in an effort to improve its exports. Just yesterday (Monday), the won rose for the sixth-straight day, its longest winning streak in eight weeks, after the nation’s foreign-exchange reserves climbed to a record $290 billion.

These events aren’t random. But they are related. They’re part of a worldwide currency war that’s being waged before our eyes – and that will prove very costly to investors who don’t recognize the game that’s being played. Fortunately, we do – and we’re going to tell you all about it.

Central Banks Duke it Out
A new global war has broken out. But this war is economic. So far, it's not a shooting war - at least, not a shooting war involving physical bullets. Yet each nation is firing financial bullets at its own currencies.

This international currency war already involves China, Japan, Brazil, Korea and even the United States, to name just a few of the main combatants, with each country's central bank taking the point position on the front line.

Through the central bank, each nation is attempting to help its own economy by lowering the value of its national currency in foreign exchange terms. The central bank that succeeds will see its country's export total zoom and will either narrow (or even eradicate) an existing current-account deficit, or (as is the case with countries such as Korea and China) will see its currency reserves soar.

You see, this war is over the ability to export finished products, to importing nations. It is about keeping your own citizens employed during an extended economic slowdown in global demand, even if that means damaging national relationships. This war will vault the winners into positions of global leadership, while severely penalizing the losers.

"We're in the midst of an international currency war, a general weakening of currency," says Brazil Finance Minister Guido Mantega. "This threatens us because it takes away our competitiveness."

Here's how this battle gets fought.

Given the budgetary jam U.S. leaders find themselves facing, they understand that one of the few options they have is to boost American exports by devaluing the dollar.

But other export-driven economies - such as Brazil, South Korea and Japan - don't want to have this happen. They want to stop the drop in the U.S. dollar. And there's only one way to stop this: Print more of their own money and then use that additional currency to purchase dollars out in the international currency market.

Once they have purchased these dollars, they usually park the dollars in U.S. Treasuries, which pay a dividend to their new foreign holder. This has helped the U.S. Treasury issue U.S. government debt at historic low interest rates - despite a staggering budgetary gulf that is threatening to widen.

As investors, there's an important reality, or rule, to understand about currency wars of this type: Unilateral actions by the central banks that are waging these campaigns on behalf of their own government are rarely successful.

Surprised? Don't be, for it gets even better. As an investor, you can profit from this easy-to-predict outcome.

Veteran institutional traders understand this reality. That's why one of the easiest trades in the professional-investor playbook has always been to go against a central bank ... after it has shot its currency wad.

News From the Front
It's well known that the central banks of the world will take action on behalf of their national exchange rates from time to time.
These "interventions," as Wall Street refers to them, are sudden-and-rapid currency moves that are usually deadly to the highly leveraged "FX" trader who takes the other end of this transaction.

While brutal and effective for periods that are measured in days or weeks, interventions are rarely characterized as successes when viewed over a period measured in months or years. The market is always bigger than any one player.

In fact, it takes a concerted effort of a group of central banks, to change market direction. It has happened before, an example being the Plaza Accord. These events are bigger than the near-term market movement, as traders understand that all central bankers are on one script.

In the current environment, however, central banks are intervening in currency markets against the best interests of each other. The brawl is actually pitting central banks against each other in the currency trading pits.

In fact, this battle has heated up so much that the U.S. House of Representatives has gotten involved. Growing ever-more concerned about the problem of the U.S. dollar being manipulated by foreign central banks, the House just last week overwhelmingly passed a bill that would enable the Obama administration to impose punitive tariffs on almost all Chinese imports into the United States. The controversial move is intended to punish China for refusing to revalue its currency.

As the world's reserve currency, the United States normally stands clear of these currency skirmishes. In this case, however, each nation is basically attempting to manipulate the U.S. dollar to its advantage.

For instance, the greenback is being held artificially stable by China's yuan policy. This enables China to enjoy any benefits the United States would normally gain from having a weak currency.

"China's persistent manipulation is a major distortion in the international marketplace," said Sander Levin, chairman of the House Ways and Means committee. The yuan "has a major impact on American workers and therefore American jobs. That's what this is really all about."

There's an old saying that you "can't tell a player without a program." So here's a quick rundown on the countries currently involved in the currency war, as well as the objective each of these players is hoping to achieve:

•China is keeping its currency, the yuan, tightly bound to the U.S. dollar, so it gains an advantage if the dollar drops in value.
•China is buying Japanese yen and European euros to hamper the exports of its rivals.
•Japan is selling yen to buy U.S. dollars, hoping to boost Japanese exports.
•Brazil is selling its currency, the real, to buy dollars, hoping to help Brazil's exports.
•Switzerland was a huge buyer of euros this spring, before switching to U.S. dollars.
This new currency war is rapidly expanding into an international economic world war that pits each combatant against all the others. Even formerly "friendly" nations - at least insofar as they'd been major trading partners - have been transformed into combatants. Each day's headlines contain examples of the breakdowns in formerly normal global trade relations. Likewise, a careful read of the daily news roundup will reveal new alliances taking shape.

Celso Amorim, Brazil's foreign minister saidthat he believes "that this idea of putting pressure on a country is not the right way for finding solutions." Amorim also noted that "we have good co-ordination with China and we've been talking to them. We can't forget that China is currently our main customer."

China has been observed selling U.S. dollars and buying up yen, which would cause Japan exports to drop in volume while increasing Chinese demand. This caused Japan to intervene in its own markets, selling as much as $20 billion in U.S. dollar equivalents in one day.

Currently, China is Japan's No. 1 export market, exceeding the U.S. in dollar value. This relationship, however, is not stable, as each nation is taking unilateral actions to defend its economy from the other. This mindset spilled over into a diplomatic crisis last month, when Japan held a Chinese fishing craft.

China responded with restricting exports of rare earth minerals to Japanese refineries during an escalation of diplomacy. It is unknown for how long this restriction will apply, but its impact on strategic planning for Japan is obviously critical going forward.

The era of "friendly globalism" is over. It's been exposed for what it always really has been - a series of negotiations. Now, however, the niceties and decorum that were always displayed to the outside world are gone, having been replaced by hard-ball/take-no-prisoners economic tactics.

In that kind of an environment, however, some very interesting profit opportunities can crop up. We'll keep an eye peeled for those profit plays in the future. For now, here are the best ones to consider.

Action to Take: In my opinion, the currency markets have become too dangerous for retail FX investors to navigate using the widely accepted, "normal" FX arrangements. After all, an FX account can have 50-1 or even 100-1 leverage.

Due to the strategic interventions central banks are engineering on an all-too-regular basis, it is now safer to hold your currency exposure in your regular brokerage account. One way to do this is via exchange-traded funds (ETFs). Some examples include:

•FXA = CurrencyShares Australian Dollar Trust (NYSE: FXA).
•FXB = CurrencyShares British Pound Sterling Trust (NYSE: FXB)
•FXC = CurrencyShares Canadian Dollar Trust (NYSE: FXC).
•FXE = CurrencyShares Euro Trust (NYSE: FXE).
•FXF = CurrencyShares Swiss Franc Trust (NYSE: FXF).
•FXS = CurrencyShares Swedish Krona Trust (NYSE: FXS).
•FXY = CurrencyShares Japanese Yen Trust (NYSE: FXY).
If the currency you are most interested in trading is not this list of pairs, you can also buy options on futures for most FX pairs. This would give you the exposure to your favorite pair that you seek - using futures leverage without taking on the margin risk.

Finally, if you are unable to find the pair you like, or are open to levels of risk above what is warranted for the typical retail investor, the FX market awaits your decision to stand in front of a government printing press that's been shifted into overdrive .

(**) Special Note of Disclosure: Jack Barnes holds no interest in any of the FX pairs listed above.

[Editor's Note: If there's one thing top global investors understand, it's that you have to "follow the money" to reap the benefits of the best profit opportunities that are available at any one time. Money flows point out the next profit opportunities. Sometimes that means "following the money" from one sector to the next. Other times that means moving from one geographic market to another.

To make those moves successfully, investors need a compass or, better yet, a guide. And successful investors will tell you, one of the best guides out there is The Money Map Report.

This monthly advisory service - an affiliate of Money Morning - employs many of the same experts whose columns you read here each day. The difference is that The Money Map Report is straight investment analysis. Our writers use proprietary money-flow indicators to identify and isolate the most timely profit opportunities you'll find anywhere. For more information about The Money Map Report, please click here.]

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Money Morning/The Money Map Report

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