Although the foreign exchange market is often billed as a banker's game, currencies can sometimes be a great way to diversify a portfolio that might have hit a bit of a rut. It's a market that can also offer tremendous opportunities when other global forums enter the doldrums.
As a result, knowing a little bit about forex, and the fundamentals behind it, can make significant additions to any trader, investor, or portfolio manager's arsenal. Let's take a look at eight currencies every trader or investor should know, along with the central banks of their respective nations.
- The U.S. dollar is the home denomination of the world's largest economy, sometimes referred to as the greenback.
- The European Central Bank holds the right to issue euro banknotes as it sees fit, while policymakers can interject at times of bank or system failures.
- The Bank of Japan governs monetary policy as well as currency issuance, money market operations, and data/economic analysis.
- The Bank of England has a Court of Directors or governing body appointed by the Crown. It also has a Monetary Policy Committee headed by the governor of the bank.
- The Swiss franc, the Canadian dollar, the Australian and New Zealand dollars, and the South African rand round out the list of top tradable currencies.
1. U.S. Dollar (USD)
The Almighty Dollar
Created in 1913 by the Federal Reserve Act, the Federal Reserve System—also called the Fed—is the central banking body of the U.S. The system is itself headed by a chairman and board of governors, with most of the focus being placed on the branch known as the Federal Open Market Committee (FOMC). The FOMC supervises open market operations as well as the monetary policy or interest rates.
The current committee is comprised of five of the 12 current Federal Reserve Bank presidents and seven members of the Federal Reserve Board, with the Federal Reserve Bank of New York president always serving on the committee. Even though there are 12 voting members, non-members—including additional Fed Bank presidents—are invited to share their views on the current economic situation when the committee meets every six weeks.
Sometimes referred to as the greenback, the U.S. dollar (USD) is the home denomination of the world's largest economy, the United States. As with any currency, the dollar is supported by economic fundamentals, including gross domestic product (GDP), and manufacturing and employment reports.
However, the U.S. dollar is also widely influenced by the central bank and any announcements about interest rate policy. The U.S. dollar is a benchmark that trades against other major currencies, especially the euro, Japanese yen, and British pound.
Although the foreign exchange market is often billed as a banker's game, currencies can sometimes be great diversification for a portfolio that might have hit a bit of a rut.
2. European Euro (EUR)
Central Bank: European Central Bank (ECB)
Current Interest Rate: http://www.ecb.int/stats/monetary/rates/html/index.en.html
The Dollar's Nemesis
Headquartered in Frankfurt, Germany, the European Central Bank is the central bank of the 19 member countries of the eurozone. In a similar fashion to the FOMC, the ECB has a main body responsible for making monetary policy decisions, the Executive Board, which is composed of four members plus a president and vice-president.
The policy heads of the ECB are chosen with the consideration that four of the seats are reserved for four of the five largest economies in the system, which include Germany, France, Italy, Spain, and the Netherlands. This is to ensure that the largest economies are always represented in the case of a change in administration. The board meets almost every week.
In addition to having jurisdiction over monetary policy, the ECB also holds the right to issue banknotes as it sees fit. Similar to the Federal Reserve, policymakers can interject at times of bank or system failures. The ECB differs from the Fed in an important area: Instead of maximizing employment and maintaining the stability of long-term interest rates, the ECB works towards a prime principle of price stability, with secondary commitments to general economic policies. As a result, policymakers will turn their focus to consumer inflation in making key interest rate decisions.
Although the monetary body is somewhat complex, the currency is not. Against the U.S. dollar, the euro (EUR) tends to be a slower currency compared to its colleagues (i.e., the British pound or Australian dollar). On an average day, the base currency can trade between 70 and 80 pips—or percentages in point—with more volatile swings averaging slightly more, at 100 pips wide per day.
Another trading consideration is time. Because the FX market is open 24/7, forex traders must strategically set FX trading schedules. Trading in the euro-based pairs can be seen during the overlap of London and U.S. sessions—which occurs from 8 a.m. through noon EST.
3. Japanese Yen (JPY).
Technically Complex, Fundamentally Simple
Established as far back as 1882, the Bank of Japan serves as the central bank to the world's third-largest economy. It governs monetary policy as well as currency issuance, money market operations, and data/economic analysis. The main monetary Policy Board tends to work toward economic stability, constantly exchanging views with the reigning administration, while simultaneously working toward its own independence and transparency. Meeting about monetary policy 8 times a year, the governor leads a team of nine policy members, including two appointed deputy governors.
The Japanese yen (JPY) tends to trade under the identity of a carry trade component. Offering a low-interest rate, the currency is pitted against higher-yielding currencies, especially the New Zealand and Australian dollars and the British pound. As a result, the underlying tends to be very erratic, pushing FX traders to take technical perspectives on a longer-term basis. Average daily ranges are in the region of 70 to 140 pips, with extremes well over 200 pips. To trade this currency with a little bit of a bite, focus on the crossover of London and U.S. hours (8 a.m. to noon EST).
Top 6 Most Tradable Currencies
4. British Pound (GBP)
The Queen's Currency
As the central bank of the United Kingdom, the Bank of England serves as the monetary equivalent of the Federal Reserve System. In the same fashion, the Court of Directors is a governing body appointed by the Crown, made up of five executive members and as many as nine others, including the chair and deputy chair. There is also a Monetary Policy Committee (MPC), headed by the governor of the bank and made up of nine members, four of whom are appointed by the Chancellor of Exchequer.
Announcing policy at least eight times a year, the MPC decides on interest rates and broader monetary policy, with primary considerations of total price stability in the economy. As such, the MPC also has a benchmark of consumer price inflation set at 2%. If this benchmark is compromised, the governor has the responsibility to notify the Chancellor of Exchequer through a letter, one of which came in 2007 as the U.K. Consumer Price Index (CPI) rose sharply to 3.1%. The release of this letter tends to be a harbinger to markets, as it increases the probability of contractionary monetary policy.
A little bit more volatile than the euro, the British pound (GBP)—also sometimes referred to as pound sterling or cable—tends to trade a wider range through the day. With swings that can encompass 100 to 150 pips, it isn't unusual to see the pound trade as narrowly as 20 pips. Swings in notable cross currencies tend to give this major a volatile nature, with traders focusing on pairs like the British pound/Japanese yen and the British pound/Swiss franc. As a result, the currency can be seen as most volatile through both London and U.S. sessions, with minimal movements during Asian hours (8 p.m. to 4 a.m. EST).
5. Swiss Franc (CHF)
Central Bank: Swiss National Bank (SNB)
Current Interest Rate: http://www.snb.ch/en/iabout/stat/statpub/zidea/id/current_interest_exchange_rates
A Banker's Currency
Different from all other major central banks, the Swiss National Bank is viewed as a governing body with private and public ownership. This belief stems from the fact that the Swiss National Bank is technically a corporation under special regulation. As a result, a little over half of the governing body is owned by the sovereign cantons or states of Switzerland and other public institutions. It is this arrangement that emphasizes the economic and financial stability policies dictated by the governing board of the SNB. Smaller than most governing bodies, monetary policy decisions are created by three major bank heads who meet on a quarterly basis. The Governing Board creates the band (plus or minus 50 basis points) of where the interest rate will reside.
The Euro and Swiss Franc have an interesting relationship. Similar to the euro, the Swiss franc (CHF) hardly makes significant moves in any of the individual sessions. As a result, look for this particular currency to trade in the average daily range of 45 pips per day. High-frequency volume for this currency is usually pitted for the London session (3 a.m. to noon EST).
6. Canadian Dollar (CAD)
Central Bank: Bank of Canada (BoC)
Current Interest Rate: https://www.bankofcanada.ca/core-functions/monetary-policy/key-interest-rate/
Established by the Bank of Canada Act of 1934, the Bank of Canada serves as the central bank called upon to focus on the goals of low and stable inflation, a safe and secure currency, financial stability, and the efficient management of government funds and public debt. Acting independently, Canada's central bank draws similarities with the Swiss National Bank because it is sometimes treated as a corporation, with the minister of finance directly holding shares. Despite the proximity of the government's interests, it is the governor's responsibility to promote price stability at an arm's length from the current administration, while simultaneously considering the government's concerns. With an inflationary benchmark of 2%, the BoC has tended to remain a shade more hawkish rather than accommodative when it comes to any deviations in prices.
Keeping in touch with major currencies, the Canadian dollar (CAD), also called the loonie, tends to trade in similar daily ranges of 50 to 100 pips. Many currency prices and commodities move together, and one unique aspect of the CAD is its relationship with crude oil. The country remains a major exporter of the commodity, and as a result, plenty of traders and investors use this currency as either a hedge against current commodity positions or pure speculation, tracing signals from the oil market.
7. Australian/New Zealand Dollar (AUD/NZD)
Always a Carry Favorite
Offering one of the higher interest rates in the major global markets, the Reserve Bank of Australia has always upheld price stability and economic strength as cornerstones of its long-term plan. Headed by the governor, the bank's board is made up of six members-at-large, in addition to a deputy governor and the Secretary to the Treasury. Together, they work toward to target inflation between 2% and 3%, while meeting eleven times throughout the year. In a similar fashion, the Reserve Bank of New Zealand looks to promote inflation targeting, hoping to maintain a foundation for prices.
Both currencies have been the focus of carry traders, as the Australian and New Zealand dollars (AUD and NZD) offer the highest yields of the seven major currencies available on most platforms. As a result, volatility can be experienced in these pairs if a deleveraging effect takes place. Otherwise, the currencies tend to trade in similar averages of 70 to 80 pips. Both currencies also maintain relationships with commodities, most notably silver and gold.
8. South African Rand (ZAR)
Previously modeled on the United Kingdom's Bank of England, the South African Reserve Bank stands as the monetary authority when it comes to South Africa. Taking on major responsibilities similar to those of other central banks, the SARB is also known as a creditor in certain situations, a clearing bank, and major custodian of gold. Above all else, the central bank is in charge of the achievement and maintenance of price stability. This also includes intervention in the foreign exchange markets when the situation arises.
Interestingly enough, the South African Reserve Bank remains a wholly-owned private entity with more than 600 shareholders who are regulated by owning less than 1% of the total number of outstanding shares. This is to ensure that the interests of the economy precede those of any private individual. To maintain this policy, the governor and 14-member board head the bank's activities and work toward monetary goals. The board meets regularly during the year.
Seen as relatively volatile, the average daily range of the South African Rand (ZAR) can be as high as several thousand pips. But don't let the wide daily range fool you. When translated into dollar pips, the movements are equivalent to an average day in the British pound, making the currency a great pair to trade against the U.S. dollar—especially when taking into consideration the carry potential.
Traders also consider the currency's relationship to gold and platinum. With the economy being a world leader when it comes to exports of both metals, it is only natural to see a correlation similar to that between the CAD and crude oil. As a result, consider the commodities markets in creating opportunities when economic data is scant.
The Bottom Line
As financial markets continue to evolve and grow globally, foreign exchange and currencies will play an increasingly large role in day-to-day transactions. Notional volumes for the market sector are already averaging over $6 trillion per day. As a result, whether a conversion for physical trade or a simple portfolio diversification play, currencies continue to offer more opportunities to both retail and institutional investors.