Currency Market Offers Opportunity But Only for the Savvy

It was already shaping up to be an unusual and dynamic year for the currency market, when the nuclear crisis in Japan caused a startling spike in the yen.

After all, its not very often that three of the world's major currencies—the U.S. Dollar, British Pound and the Euro —display simultaneous weakness, while a handful of currencies from commodities-rich nations — the Australian and Canadian dollars, Brazilian Real and Norwegian Krone—show widespread strength. Then, there's the appreciating currencies of emerging markets, which continue to attract hot money.

On top of that there are powerful policy initiatives at work—from the Federal Reserve's QE2 monetary stimulus to Europe's belt-tightening—as well as the usual guessing game about which central banks will raise interest rates first.

Put together, it makes for lots of opportunities for new currency pairs and cross-rate plays — and with a new generation of low-cost, online currency trading platforms, retail investors can play the world currency stage.

You'll need to know a bit about monetary policy and economic fundamentals. And you need to know the risks. With that in mind, here's some background on the market and the major currencies.

The Playing Field

With U.S. interest rates at virtually zero and a ballooning budget deficit, the dollar is weak, making other G7 as well as emerging-market currencies more attractive.

“We’re concerned the fiscal backdrop in the US is not being addressed in a credible way," says Robert Lynch, head of currency strategy for HSBC, and one of the many who is bearish on the dollar. "Foreign investors are holding a great deal of our debt, and they may become concerned about the United States' ability to repay, in a way that will potentially weigh on the dollar this year.”

Japan was already struggling to contain the yen's appreciation against the dollar when the nuclear crisis erupted, which gave it a further boost against the American currency as well as other major ones.

Citigroup's senior G10 foreign exchange strategist Greg Anderson is expecting a weak yen in the medium term, which he says would be good for Japan’s recovery, and good for G10/yen pairs.

“I believe Japan will ultimately defend the 80 level with intervention," says Anderson. "[The]dollar-yen [level] has been in the low 80s for over six months—which is a critical level, because it’s an all-time low. What’s best for [Japan's] economy is a weaker yen. If they see the yen strengthen they will intervene. In a panic, the yen strengthens. So officials are making yen plentiful, instead of scarce. If the price of yen goes down, Euro/yen and dollar/yen plays go up. It should be positive for the G10,” says Anderson.

Handful Of Favorites

Steven Englander, head of the G10 foreign exchange team at Citigroup, says his first choice is the British Pound Sterling.

“We’ve been bullish on sterling for last two months. We’ve come from $1.55 [vs. the dollar] to $1.63 this year. That’s a nice rally. We expect it to get to $1.70 by the end of this year. The next move will occur in the second quarter.”

Englander is also predicting sustained economic recovery in the U.K.

“They’ve done a lot of things the U.S. has been too scared to do. Last year they raised taxes and laid off government workers. They dared do it — and their economy will turn out just fine despite headwinds — but the market will have to see that before we’ll see the $1.70 target.”

In contrast,  no one seems convinced that the Eurozone’s sovereign debt crisis is in the past.

Brian Kim, foreign exchange strategist at UBS, is bearish on the Euro, especially given recent remarks by European Central Bank President Jean-Claude Trichet’s indicating a rate hike is near.

“They’re signaling an April move," says Kim. "We’re looking for 25 basis points [a quarter percentage point] for the first move. The market is supportive for the near term. But the sovereign debt problem is still an issue. These countries need to clamp down on their budget deficits. We prefer not to play this currency. It has the support of a hawkish central bank, but we think that after a couple months pass, the initial euphoria will taper down,” Kim adds.

Then, there's the so-called commodities-driven currencies of countries rich in natural resources, from grains to metals to fossil fuels: Canada, Norway, Brazil, Australia, for instance.

“Norway has our favorite currency because it has the best fiscal position among developed economies," says HSBC’s Robert Lynch. "It hasn’t appreciated anywhere near the extent to which other commodity currencies have, like the Australian dollar. And certainly the recent rise in price of oil has the potential to support Norway. We see the others as either fully, or overvalued.”