The safest way to play the currency markets

With the pound shedding value at an alarming rate, shorting sterling looks like a good bet. But before you pile in, beware. Every major currency is in a mess, so the pound may not be the whipping boy for long. But there is one long-term currency trend you can be sure will continue. John Stepek explains what it is and how to play it.

By John Stepek

published 2 March 2010

in Features

Sterling tanked yesterday, tumbling to its lowest in nearly a year against the dollar. Why?

You might be better to ask: "why not?" There are plenty of reasons to hate the pound. The big one is political risk. With the recent batch of opinion polls showing that Labour might even win the next election, investors no longer feel confident that they know who'll be running the country in less than four month's time.

Then there was Bank of England lending data. The number of home loans approved for new house purchase dived 17% month-on-month in January, falling to near 48,000. And on top of that, insurer Prudential's decision to buy US group AIG's Asian business also had an impact. The $35bndeal means it'll have to sell a lot of sterling.

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So there are lots of reasons to hate the pound. Getting in the queue to sell looks a no-brainer. There's just one problem most other major currencies have almost exactly the same problems

You should think twice before you start trading currencies

One thing sums up all you need to know about sterling's fall yesterday, says David Wighton in The Times - the pound even declined against the Zimbabwean dollar. That's pretty damning. "Gordon Brown has been accused of many things. But the prospect of his re-election resulting in Robert Mugabe's currency being preferred to sterling must surely be one of the most hurtful." And analysts lined up to deliver new targets for the pound yesterday, ranging from around $1.40 to $1.20 and below. So is it time to pile in and short sterling?

It's certainly easy to do. And the outlook for the pound is grim. But there are a few reasons why you should think twice before you decide to start trading currencies. US writer Porter Stansberry made some very good points in his DailyWealth newsletter yesterday. He recently attended a meeting where a US wealth management firm was trying to encourage well-off private investors to start speculating on currencies, using a 'carry trade'-style strategy. They would borrow in the lowest-yielding currencies and invest in the highest yielding.

The strategy has worked pretty well in the past. But, says Stansberry, that doesn't mean it's going to keep working. "I'd never seen a Wall Street firm give a leveraged currency presentation to retail clients before. In my experience, whatever the big brokers are pitching to retail clients, that's the thing most likely to blow up next. One year it's dot-com stocks, one year it's mortgage-backed securities, one year it's commodity futures, and so on"

All the world's major currencies are in a mess

The real problem, as Stansberry points out, is that all the world's major currencies are in a mess. And the system isn't founded on gold any more. In fact, the main thing backstopping the global monetary system is US government debt. Given that the US's deficit is little better than that of Britain or Greece, that's not encouraging. As Stansberry puts it: "The largest reserve assets of the world's monetary system are the obligations of a bankrupt nation (the US) that must print money to afford its own annual deficits."

Why UK property prices are going to fall 50%
When it will be time to get back in and buy up half price property

You can argue that forex trading is a zero-sum game. And so regardless of how awful conditions are for each paper currency, if one is falling, another has to be rising. However, the point is that judging this is going to become ever-more difficult. If every currency is vulnerable, then it only takes a few ill-judged words from a central banker or a politician (or a scary opinion poll) to knock a currency off its perch.

For example, one reason why sterling is taking the most flak this week is because investors have decided that Germany will bail Greece out. So for the time being, they reckon the UK looks like Greece, only without the Germans standing behind it. But it only takes a crisis in Spain, or a big fat "nein" from Berlin, to put the euro back in the firing line again.

"What will happen to these [currency trading] strategies as volatility soars and the large currencies collapse? No one knows. But one thing I do know for sure. It won't end well for retail investors."

It's not to say that you can't bet on currency movements. We believe in the short-term, the dollar is still a decent bet to go higher, particularly against the euro. And if you have a pot of money that you're happy to bet with, and can afford to lose, then spread betting can be a fun way to do it (you can compare providers here, using our spread bettingcomparison service).

But for goodness' sake set a stop-loss and stick to it. And don't ever imagine for a moment that betting on currencies is investing, regardless of how many companies launch 'carry trade' or 'short euro' exchange-traded funds. This is an area of the market which is only going to become ever more volatile and unpredictable as sovereign debt problems start to explode across the world.

Protect your wealth with gold

If you want to profit from the most significant long-term currency trend the loss of faith in government-backed money then you should buy gold. I realise that some readers find it hard to understand why we keep going on about this. But gold hit a record high against sterling yesterday (more than £740 an ounce). Eurozone gold buyers also saw record prices in recent weeks. So in terms of protecting your wealth, the yellow metal is doing pretty well so far.

If and when governments finally decide that protecting the value of paper money is more important than keeping the illusion of short-term economic growth on the road, gold's bull market will be over. Sadly, I suspect that's a while away yet. Dr Marc Faber of the Gloom, Boom and Doom report reckons that 'real' interest rates (i.e. adjusted for inflation) in the US won't move into positive territory "at any time in the next 10 years." If your paper money is losing value, why wouldn't you hold gold?

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.