Fundamental Personalities of Currencies

If each currency’s value is a reflection of the underlying economy of its country or
region, we can begin to think of them as having a fundamental personality that can
guide our strategies for trading. This chapter focuses on how a trader can gain an
understanding about the strength and weakness of a currency. The concept of a tradeweighted
currency basket is introduced as well as how to obtain the latest trade-weighted
information and data that can be directly used in trading.
TRACKING CURRENCY STRENGTH: HOW STRONG
IS A CURRENCY?
In reviewing the “big” fundamental picture for a currency, we have reviewed what moves
forex prices from an economic point of view. We can be convinced that currencies reflect
world opinion about how well an economy is doing or expected to do. The next step in
fundamental analysis is to be able to make a judgment about a particular currency itself.
Ultimately, the question arises for the trade: How strong is the currency? In spot forex
trading, the trade itself is always a paired event of one currency against another. But
when a trader makes a judgment about the strength or weakness of a currency by only
comparing one currency against another (usually the U.S. dollar), the conclusion can be
misleading as to the global strength or weakness of the currency. When trading majors
where the U.S. dollar is part of the pair, the comparative question becomes: How strong
is the U.S. dollar against that currency? It’s important to get an insight on how strong
a currency is with respect to its total global trade position. To enable an answer to the question of how strong a particular currency is on its own terms without reference to
another pair, the trade-weighted index (TWI) is used by economists and should also be
used by currency traders.
The TWI represents how well the currency of a country is doing against a basket
of other currencies. The currencies included in the TWI are those that reflect the major
trading relationships with the index currency. Each currency receives a weight in the
index that reflects its importance. For example, in Table 7.1, we can see that Japan is
Australia’s major trading partner and has the greatest weight in the Australian TWI. We
can also see that Canada and many other nations have a very small percentage component
of the TWI.
Each year the central bank and economists adjust the weights to reflect changing
realities of international trade. As China increases its trading relationships around the
world, it will receive more weight in TWIs. The point is that the TWI represents a way of gauging the change in value of a currency in terms of its global trading position. By
knowing the TWIs of each currency, the forex trader can detect a strengthening and
weakening of a currency and also get a sense of how a currency can be impacted by
events in countries of their trading partners.
Many traders often ask the question: What do you think of the U.S. dollar (or yen,
pound, or euro)? One important way of answering is from the perspective of the TWI.
Each currency gains a trading personality, and knowing the TWI for each currency is
very useful, because it will reflect the big picture much more accurately.
Most recently, the International Index Company issued a new product line called
iBoxxFX®, which are indices that are, in fact, trade weighted. They allow an average
forex trader to take a snapshot of the strength of a currency without the noise of the forex
market. Table 7.2 shows the iBoxxFX® currency baskets for each currency. Notice how
each currency index reflects the varying importance of its different trading partners. We
will see shortly that these trade weights are a clue to defining the fundamental personality
of a currency.


By ABE COFNAS