Ever heard of cross rates?
If you trade the foreign exchange market, you certainly have. If you merely dabble in currencies or global investing, then maybe you have.
Because if you remove the U.S. dollar from the equation, the world of currencies is made up of cross rates.
Cross rates are simply a foreign-exchange rate — one currency compared to another — that do not include the U.S. dollar.
The value of the euro compared to the British pound, for example, is a cross rate. It is EUR/GBP.
Every currency can be crossed with any other currency, though only the most active cross rates tend to be utilized by currency traders.
For today’s discussion on what to do about Thursday’s Brexit referendum, I think we should start by looking at a key cross rate that’s reflecting some market distortion: GBP/JPY.
Would you rather have …
A Briefcase Full of British pounds or Japanese yen?
Based on the limited volume of a briefcase, the answer is quite easy …
Give me British pounds, please.
But the last year has proven that traders looking to make profits or preserve value have preferred Japanese yen. This chart shows the extent of the British pound’s decline relative to the Japanese yen in the last 12 months:
GBP/JPY is down 25% in the last 12 months and 17% in the last five months.
That’s a substantial decline after an even more impressive bull market. And it begs the question: What is driving this cross rate pair?
In January 2013, British Prime Minister David Cameron promised a referendum vote if the Conservative party won the 2015 general election.
They won majority in May 2015.
And the pound has been losing value to the yen ever since. Most notably since the European Union Referendum Act of 2015 was approved in December of last year.
The basic point of a referendum is to let the British citizens vote to decide if they want to remain part of the European Union.
The last time British citizens got such a vote was in 1975 when they opted to stay.
But back then the union was primary an economic group. Today the EU is primarily a political monstrosity.
So much for sovereignty.
But let’s not get sidetracked — you want to know what to do about this Brexit vote in three days.
Keep Calm and Carry Pounds
I think you’d be better off filling up that briefcase with British pounds before the Brexit vote.
Similarly, you might want to unload those Japanese yen.
If Brexit comes and goes as I expect — uneventfully, regardless of whether they stay or go — then the markets’ recent worries will prove overblown and ripe for a reversal.
That means the British pound catches a bid … and risk appetite probably does too.
Last Thursday, the day after the Federal Reserve announcement, the Japanese yen was stronger even though all other major currencies were getting creamed by the dollar.
That tells me risk aversion — capital flight — was what was driving the Japanese yen. (The yen has become a perennial carry trade currency. So, it tends to be a recipient of capital flight to cover the yen borrowings used to fund riskier investments.)
How do you play it?
Well, I like to use options on currency ETFs.
Options provide leverage without the unlimited risk of trading in the foreign-exchange market.
In fact, I’ve already given subscribers to my new Currency Options Alert a recommendation on how exactly to play the Japanese yen.
I suspect a reco on the pound will make sense soon.
But if you don’t want to use options, you can buy the ETFs. To capitalize on the distortion in GBP/JPY I described above, I’d recommend buying shares of the CurrencyShares British Pound Trust (FXB) and an equal dollar-sized amount of the ProShares UltraShort Yen ETF (YCS).
Or, if you like to play with the big boys in the spot forex market, consider grabbing up a few lots of GBP/JPY and sitting on it for a few months.
If you do that, and I’m right about this, they might be mentioning your name in the same sentence as George Soros before you know it!