How to Choose a Currency Pair

The primary goal of forex trading is to earn good profits regularly. However, the profit amount depends on the liquidity of the currency pair traded. A liquid currency pair is lucrative because it attracts a big chunk of the market’s money. Even then, you have certain tricks to choose a pair that suits your needs as well as trading style.

Choosing a currency pair might seem an easy task. One could go for the most popular pair, say EUR/USD or the Fiber. The Fiber is attractive because it contains the world’s top two reserve currencies. It means their demand is high, so is their liquidity. Nonetheless, you might find it surprising that the pair is not right for your trading style.

The first step to choosing a suitable pair is to identify its behavior. Some currency pairs are trending, while others are multidirectional. Each behavior calls for different trading strategies as well as individual levels of sophistication. For instance, a trending pair is easy to trade since you only need to make good use of trend indicators.

The second step involves figuring out your trading strategy. If the behavior of the currency pair matches your trading strategy, then the pair is the right one. Use indicators such as the true average range (ATR) to better understand the pair’s day-to-day movement. This information should help you to construct the most suitable trading strategy.

What Affects Currency Value?

For starters, a currency pair is a conglomeration of two currencies. The behavior of each currency determines the ultimate value of the pair. As such, successful traders must know what affects currency value and understand how the currency value is affected.

The health of the economy

Investors use the term “health” to refer to the condition of the economy. For example, an economy in good health has moderate inflation and low unemployment rates. The health of an economy has the most significant influence on the value of a currency. Investors judge the future value of a currency based on whether they believe the economy’s health is strong enough to sustain the value. 

Certain information enables investors to evaluate an economy’s health. For example, the US Fed releases the Industrial Production Index (INDPRO) monthly. The data indicates the output in the US industrial sector. For investors, the US economy is healthy when INDPRO beats estimates. Consequently, the investors will go long on the US dollar, which sets currency pairs like EUR/USD into a bearish trend. 

Notice in Figure 1 and Figure 2, the value of the EUR/USD pair declined as INDPRO values climbed higher. Between January 2010 and January 2020, INDPRO value grew by 19% to 109.2128 (Figure 1). In the same period, the Eurodollar exchange rate declined by about 23% to 1.1120 (Figure 2).

US Industrial Production Index (INDPRO)

Figure 1: US Industrial Production Index (INDPRO)

EUR/USD Exchange Rate, 2010-2020

Figure 2: EUR/USD Exchange Rate, 2010-2020

Political Stability

The politics of a country either reinforce or undermine the health of the economy. Usually, investors see political tension as a harbinger of a coming economic crisis. The result? They try as much as possible to avoid currencies whose home countries/regions are in a political crisis.Trend trading investors emphasize the fundamentals of a currency when determining to create their strategies. Indeed, political stability is one of the fundamental issues that affect a currency’s value. 

How does political stability affect currency? Consider the Euro. In the last five years, the European Union has faced immense destabilizing pressure from the UK’s exit. Fears of a possible Brexit began to spread in the market in the first quarter of 2014. By mid-2015, the UK parliament passed the motion affecting a Brexit referendum.Consequently, the Euro ceded huge ground against the greenback. Between May 2014 and December 2016, the EURO decline against the USD by 24% to 1.0451. 

EUR/USD Decline Due to Political Instability in the EU

Figure 3: EUR/USD Decline Due to Political Instability in the EU

Market Risk Appetite

Forex trading is a risky activity. In a bullish market, traders are willing to take significant risks because they believe they could earn bigger profits. However, one’s risk appetite could also lead to a massive hemorrhage of funds. It is true when the market moves against traders’ positions. Consequently, market risk appetite collapses.

The Volatility Index (VIX) created by CBOE is the world’s best indicator of market risk appetite. VIX is primarily an index for the equities market, but its relevance cuts across all financial markets in the US and globally.

In periods of elevated VIX readings, market fears are high, and risk appetite is low. It means traders are unwilling to hold risky assets in favor of a more stable currency like the USD, CHF or JPY. Primarily, investors want to store value in currencies that offer more stability. Notice in Figure 4 and Figure 5 below, the value of EUR/USD was at the lowest when VIX was at the highest year-to-date in 2020.

 

EUR/USD YTD 2020

Figure 4: EUR/USD YTD 2020

VIX Chart YTD 2020

Figure 5: VIX Chart YTD 2020

GDP Growth Rate

The rate of an economy’s growth speaks volumes concerning the future value of a currency. As shown early herein, a healthy economy is one whose key data meets or exceeds expectations. Earlier, we showed that increasing INDPRO values imply a healthy economy. Investors use such figures to shape their view of the currency. A healthy economy reinforces the value of the currency and vice versa.

Various factors affect the rate of growth of GDP. In itself, the rate of growth tells traders how key sectors of the economy are performing. High GDP growth rates indicate an economy that utilizes the potential of supply and demand-side to the fullest. Strong demand within an economy reinforces the purchasing power of the domestic currency. As a result, the currency firms against rivals. If the US were to report higher GDP growth rates every quarter consistently, then the USD is likely to firm against the EUR and other rivals. 

Credit Rating

Economies borrow funds frequently from both the domestic market and the international credit markets. These funds, often, go into development projects that culminate in stronger economic growth. Just like any other borrower, sovereign countries have a credit rating that guides the pricing of loans by creditors. 

The credit score determines a country’s ability to borrow from international credit markets and the much it can borrow. Before a debt issue, a country approaches a credit rating company such as Moody’s to conduct an assessment. At the end of the process, the company gives a credit score that creditors will trust. 

A favorable credit score means a country can issue debts at a lower cost. For traders, this indicates the strength of the country’s economy. A more robust economy attracts traders to its currency, making it superior in value in the market. A creditworthy economy is capable of storing the value of traders’ assets. 

Central Bank Interest Rate

Central banks are the government’s agent in the forex market. Through various activities, central banks influence the exchange rate of a currency. The activities include setting policy rates and open market activities. Put together, and the activities make up a country’s monetary policy.

The cardinal function of a central bank like the US Federal Reserve is to regulate the economy’s flow of money. Termed liquidity, money flow affects inflation rates as well as unemployment rates. For instance, inflation is higher when liquidity is high, and unemployment is low. 

Traders keep a keen eye on the central bank interest rate because it affects a currency’s interest rate via investor activity. Higher interest rates make a country’s fixed debt more profitable hence more demand from foreign investors. The ensuing demand for the domestic currency to facilitate bond-buying activity leads to firming of the currency. Alternatively, the central bank can buy its currency from the market to bolster its exchange rate. 

Conclusion

Traders have to keep a keen eye on various factors that move currencies. These factors are fundamental to the future value of the currency. For instance, the GDP growth rate of the economy implies a strong currency going forward. The market trusts such a currency to store the value of their wealth hence increased demand for the currency.

Political stability lends strength to a country’s economy. Traders believe that strong political institutions reinforce the efficiency and productivity of the economy. In that sense, confidence in the domestic currency is high. 

Besides, the amount of risk traders are willing to take also affects a currency’s value. A high-risk appetite means traders prefer riskier currencies. However, traders favor low-risk currencies when market fears heighten. That means risky currencies decline in value. Central banks’ actions also hugely influence the value of a currency. It happens through direct market activities or adjustment of the policy rate.