One Anomaly, Two Currency Trades to Profit from It

I cut my teeth trading the foreign-exchange market.

Foreign-exchange rates — currencies — trade around the clock, six days a week. And the daily volume in currencies exceeds any other market on the planet by a long shot.

The foreign-exchange (forex) market’s constant action and high leverage is heaven on earth for traders who can get their fix quickly, even when other markets are sleeping.

But it doesn’t have to be like that.

For instance, I’ve since pulled back from the hour-to-hour grind of forex.

My focus on currencies is on a level that fits with my preferred trading indicators and time frames. (Think days and weeks instead of minutes and hours.)

And as it relates to serving our subscribers, my currency trading ideas don’t require accessing the foreign-exchange market directly.

I’ll get to that in a moment, and two trades you can consider right now …

But let me first explain the anomaly that underpins the opportunity I see in currencies right now.

What Do Currency Traders Care About?

Day traders care about price action only. And maybe event-driven volatility.

Someone with a longer-term view, someone with exposure to a particular currency, cares about more than just day-to-day price volatility.

They care about longer-term drivers.

Ultimately there are two fundamental forces that drive the value of a currency:

1. Economic Growth

2. Interest Rates

Before I go any further, always remember that those two items are relative in the currency market.

For most investors who have long-term exposure to a single currency, growth and interest rates in the underlying country should be viewed relative to those in the United States. That’s because currencies are primarily valued relative to the U.S. dollar, the world’s reserve currency.

Now, for the sake of this piece, let’s ignore the growth component of valuing a currency. After all, most major economies around the world are in a pretty similar place: low and slowing growth.

To be sure, the two drivers — growth and interest rates — are not mutually exclusive.

But interest rates get all the attention these days.

Central banks have pretty much ensured that major currencies will be driven primarily by interest rates. The higher the benchmark interest rate in one country, the more capital will flow into the underlying currency and drive it higher. So …

  High relative interest rate = stronger currency.

  Low relative interest rate = weaker currency.

There are some exceptions.

For example, the Brazilian real has absolutely collapsed vs. the U.S. dollar. This is despite interest rates in Brazil being tremendously higher than in the United States.

Growth has been the driver in this case, as Brazil is battling strong recessionary pressures.

Other emerging-market currencies are similar — interest rates aren’t always the deciding factor when capital flows there depend more upon Federal Reserve-driven liquidity.

So let’s just assume the interest rate dynamic is pretty accurate in valuing the U.S. dollar’s major counterparts: the euro, Japanese yen, British pound, Swiss Franc, Canadian dollar, Australian dollar and maybe a few others.

All of those currencies have undergone depreciation in the last two years because of interest-rate expectations.

As the Fed laid out an exit strategy and sought indications that it should normalize interest rates in the U.S., investors saw little reason for other major central banks to follow suit.

The result?

The U.S. dollar got stronger.

Everything else?

Weaker.

And we sit today with interest-rate expectations thoroughly baked into the value of major currencies, guessing the best we can at what the Federal Reserve will do next.

Ultimately, I don’t think the Fed can raise rates again soon. (Other traders agree. The CME FedWatch tool puts the odds of a rate hike at the Fed’s March meeting at just 8%, and not much higher for the rest of the year’s meetings.)

While that alone won’t sink the dollar, the U.S. dollar’s climb will be limited unless another central bank takes desperate action.

Right now, though, there appears to be an anomaly in two major currencies.

Their values don’t seem to be properly reflecting their underlying interest rates.

I’m talking about the Japanese yen and the British pound.

Time to sell the Japanese yen and buy the British pound?

The Bank of Japan recently announced it will adopt negative interest rates.

Conceivably, a move to decrease the benchmark rate of interest should cause a similar drop in the value of the Japanese yen relative to the U.S. dollar.

Instead, the opposite happened.

The yen strengthened relative to the U.S. dollar even though Japanese interest rates fell.

The British pound also appears unfairly valued at the moment.

Instead of interest rates changing, it is the currency that has adjusted to reflect fears/expectations that the UK will exit the European Union ("Brexit").

The pound seems to have over-adjusted.

First, I’m not sure a "Brexit" is a bad thing for the currency. But uncertainty seems to be a negative for traders at the moment.

Second, the Bank of England is probably not far behind the Federal Reserve in its aim to normalize interest rates. The "Brexit" action in the British pound seems to have become disconnected from underlying UK interest rates.

The chart below, similar to the one above, shows the British pound relative to the Japanese yen (rather than the U.S. dollar).

In case I’ve confused you, let me summarize what this analysis suggests …

  Sell the yen.

  Buy the pound.

If you’re trading forex, all you need to do is buy GBP/JPY to play this anomaly.

But if you’re not interested in trading spot forex, there are other ways to target these currencies.

ETFs and Options

Guggenheim CurrencyShares ETFs offer access to major currencies relative to the U.S. dollar … directly on U.S. exchanges.

There are other U.S.-listed ETFs with direct currency exposure as well.

The CurrencyShares British Pound ETF (FXB) and the ProShares UltraShort Yen ETF (YCS) are the ones to use if you’re looking to trade this anomaly.

(Note: YCS is an inverse fund that gives investors "short" exposure to the yen without having to "sell short" any shares. YCS is also designed to move twice as fast as the underlying moves in the Japanese yen. Be sure to keep a very close eye on this trade if you decide to act on this idea.)

YCS shares currently trade for nearly half as much as FXB shares. So, I suggest buying an equal number of shares of each.

If you’re buying shares, however, a short-term anomaly like this one might not really pay off for you very soon. In order to see a sizeable gain, this move would need legs.

Based on the underlying drivers for the Japanese yen and the British pound, this trade certainly could have some legs.

But if you’d prefer to capture a nice gain in a shorter amount of time, consider options on these ETFs.

  FXB is trading at $136.38.

  YCS is trading at $77.02.

You could buy a measly 10 shares of each ETF for the same price you could buy some call options.

And if this trade goes according to plan, options should pay off substantially more than a comparably-sized investment in shares of an ETF.

It’s how I’d do it.

Do right,

JR Crooks

“JR” specializes in trading commodities, currencies and options. He has spent nearly 10 years analyzing financial markets and writing about global economics. JR honed his trading techniques and global-macro worldview alongside his father, Jack Crooks, at Black Swan Capital. JR also …