Where to place your bets in the currency markets

Everyone's getting into currencies the launch of exchange-traded products has made it even easier to do so. John Stepek finds out whether you should.

The top 50 list of iPhone apps isn't somewhere you'd normally think of looking for a financial leading indicator. But in between playing games and looking at smutty pictures, people are using their little mobile-phone touchscreens for something quite different betting on the currency market.

It's little wonder. Stocks might have recovered sharply in the past year, but many ordinary investors have had their fingers burned once too often in the equity market. Two massive crashes inside a decade would destroy anyone's faith in an asset class. And the great thing about the currency market is that it's highly liquid trillions of dollars' worth changes hands every day, way more than even the largest equity markets. So you'll never get trapped in an illiquid holding.

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On top of that, there's the uncertain economic outlook. Low interest rates and money-printing by governments may have propped up markets for now, but how long can that last? There could be very tough times ahead for most asset classes, from bonds to stocks to property. Currencies, on the other hand, are a zero-sum game if one goes up, another has to be going down. So, as currency traders like to say, "there's always a bull market somewhere".

There's just one problem. Which currency do you bet on? Trying to choose the ugliest candidate in this particular ugly contest isn't an easy matter. That's one reason why we think getting into forex trading right now is even more risky than usual. But before we talk about that, let's look at the state of the major currencies.

The pound

So far, 2010 has been a bad year for sterling and it's only March. It doesn't take a genius to see why. The economy is very weak. The Bank of England is still warning that it might have to print more money, so higher interest rates seem to be off the cards for now, despite rising inflation. Meanwhile, Britain is suffering from a huge budget deficit at more than 12%, it's on a par with that of Greece. That's got investors worried about how we'll repay our debts. And on top of that, the country can't seem to make up its mind about who to vote for in the next election. A hung parliament, which might result in political paralysis the British aren't used to coalition governments could make getting to grips with the deficit even tougher.

So it's small wonder that sterling has been beaten down. But a lot of the bad news is in the price, reckons John J Hardy at Saxo Bank. As he pointed out earlier this month, the pound is at its weakest in 25 years against the Australian dollar, currently one of the strongest currencies around. There are good reasons for this. But "market history has shown time and again that mean reversion is a powerful force in a free-floating currency market... our outlook is cloudy for the pound, certainly everything looks awful, but a lot of that awfulness has been discounted".

The trouble is, while a short-term punt on the pound against selected currencies might work, we suspect sterling will be very volatile between here and the election, with every economic data release not to mention the Budget sending it soaring or diving. And even if there's a decisive result in the election, any sterling bounce might be short-lived as investors realise what lies ahead.

The scale of spending cuts needed by Britain to tackle the deficit is huge, even if it's done over a number of years. And shifting the UK economy away from its dependence on the financial and public sectors will take a long time. As Lex put it in the FT: "While the UK rebuilds its skills gap, the economy may well need not just a weak exchange rate but an ultra-cheap one. Sterling could yet take a bath too." So in all, sterling looks ugly. Until you consider the competition.

The euro

This week, the euro bounced back after credit rating agency S&P removed Greece from its negative credit watch list. It's still on probation, but for now, S&P views "the government's fiscal consolidation programme as supportive of the ratings at their current level".

So everything's all right now? No: the Greek crisis hasn't been resolved, it's been postponed. The trouble is, according to David Owen of Jefferies Fixed Income, no state in modern history has achieved cuts on the scale Greece is attempting during a recession. And if Greece steps out of line, it'll be back to square one with the credit rating agencies.

If it was just Greece, it might not be a problem. But there are Italy, Spain and Portugal to worry about too. That's another reason why the Germans seem reluctant to make any bail-out plans for Greece concrete the fear is that as soon as a mechanism is in place, the others will want to take advantage.

So what next for the euro? Gabriel Stein of Lombard Street Research has an interesting take. Stein says Germany may in fact be happy to let Greece leave the eurozone. This would create a precedent for pushing unsuitable countries out of the single currency. And "once the major periphery countries are out, leaving the core, the euro is likely to be strong the true successor to the deutsche mark that Germany always wanted".

Of course, even if this view is correct, it's a long way off. And before that point, the euro would have to go through the upheaval of shedding its weaker links and going through the political pain that would imply. So in the short to medium term at least, we reckon the euro is heading for further weakness.

The dollar

The Federal Reserve, headed up by Ben Bernanke, has no plan to raise interest rates in the US any time soon. The US economy is still in a grim way, with a fragile housing market and 10.4% unemployment. The Greek and UK deficits might draw all the attention, but America is no slacker when it comes to rampant public borrowing: its deficit for last year came in at nearly 10%.

But none of that matters at least, not right now. That's because the dollar is still the world's reserve currency. Global central banks and institutions hold more dollars than they do anything else. Global trade is largely conducted in dollars. And when investors get scared, it's the dollar they run to. During the financial crisis in 2008, the dollar leapt as people retreated en masse to 'safe' dollar assets. After the markets bottomed in March 2009, the dollar weakened drastically.

But it's been rising again recently. In the long run, America's debts will catch up with it. Indeed, Moody's warned just this week that America's AAA credit rating could conceivably be at risk. But with markets likely to focus on sovereign debt problems elsewhere this year, not to mention the threat of China's economic activity slowing, there's plenty of scope for investors to retreat to the perceived safety of the US dollar all over again.

The yen

"The yen should weaken and will weaken," declares Goldman Sachs. The investment bank reckons that a weaker currency is Japan's best route out of deflation. But how will it get there? Japan has an advantage in that there is no pressure on its central bank to start raising interest rates the economy is still mired in deflation. While other central banks are at least trying to exit quantitative easing (however temporary that may be), plenty of people would like Japan to try more. The current Japanese finance minister is also keen to "stem sharp yen appreciation", as Bank of America Merrill Lynch analysts put it.

And even if the yen fails to fall much against the dollar, it should decline against other Asian currencies, which are at very different points in the interest-rate tightening cycle. This would be great for Japanese exporters including China, Asian markets account for more than 55% of Japanese exports. "The Japanese economy and share prices are now much more sensitive to Asian currencies due to structural change in trade, including higher levels of competition with Asian companies." So if other Asian currencies rise against the yen, it boosts Japanese competitiveness and is "a source of growth for Japanese goods and services exports via the transfer of purchasing power to Asia". For us, this is a strong argument to buy Japanese stocks rather than the currency.

The commodity currencies

So what of the so-called commodity currencies? The Canadian dollar (also known as the 'loonie'), the Australian dollar, the Norwegian krone and the New Zealand dollar are all backed by countries with significant natural resources. That should make them better bets, surely?

The trouble is, both commodities and the commodity currencies look pretty expensive. Strong commodity prices in general have largely been dependent on Chinese demand, with the Australian dollar probably the biggest beneficiary. "The biggest threat," says Saxo Bank, "but also the most difficult to time is the significant risk of a Chinese slowdown." This "would have massive implications for Australia's commodity exports as well as commodity prices in general". But even if China doesn't stop buying for now, the good news looks pretty well priced in.

So what should you do?

In short, the outlook for currencies is more volatile than ever. The threat of the US and China getting into a protectionist spat over the renminbi merely adds to the potential risks out there. Overall, we believe there's likely to be a growth scare this year, which will drive investors away from risky assets and related currencies, and towards the US dollar. And if there's going to be a sovereign debt crisis, then it'll probably be somewhere in Europe, which would clearly hurt the euro.

So if you're happy to risk spread betting the currency markets, then we'd agree with Jim Mellon, chairman of Burnbrae Capital, who reckons you should short the euro against the dollar at $1.3760, with a year-end target of $1.31. Mellon also thinks it's worth shorting the yen versus the dollar his target is 99. And if you're feeling very adventurous, Saxo Bank's suggestion that contrarians might want to buy the pound against the Australian dollar looks like it could be a winning play on mean reversion although we'd make sure it was a short-term trade. For more on timing your trades, see Dominic Frisby's article: How to turn yourself into a chartist .

But overall, we're cautious on the idea of betting on currencies. The push to drive more retail customers towards the currency market with the launch of exchange-traded currencies and other products that target longer-term 'investors' is a worrying sign that currencies are where private investors are likely to lose their next big fortunes. For ways to diversify your currency risk rather than bet on a specific pair, see below.

Safer ways to play currencies

If you want to bet on currencies, then spread betting is one of the easiest options. For more on spread betting, and to find an account provider, go to www.moneyweek.com/SB.aspx. We have already looked at some trades you might want to make above. But it's important to understand that you are betting. And as with any form of gambling, most people lose money. So it's not an option for your pension.

Gold

If you want to invest in a genuine long-term currency trend, then there's only one currency trade that works for us long gold, short paper currencies. That bet would have played out well over the past decade.

You can buy gold in a number of ways. The least hassle is to buy a physically backed exchange-traded fund (ETF), such as ETF Securities Physical Gold (LSE: PHAU).

Of course, if you're a regular MoneyWeek reader, you've probably already got gold in your portfolio. So what else can you do to minimise your currency risk? It's worth remembering that as long as your income and your liabilities match, then currency risk isn't going to be number one on your list of worries. If your mortgage is in sterling and your wages are too, then a falling pound hits both your assets and your liabilities, so it doesn't matter.

Defensive, blue chip stocks

But with the outlook for most of the major currencies so uncertain, some diversification in your longer-term investments is a good idea. Of course, you should never buy an asset simply based on the currency it's denominated in. But if the underlying company is good, then you can see the currency diversification as a bonus. Right now we're keen on defensive, blue-chip stocks. The good thing about most of these companies is that they're global in scale, so they make money in a wide range of currencies. Even better, you now get a wide range of such shares outside Britain as well. Within the last month, my colleague David Stevenson has highlighted several European stocks that fit the bill. German energy giant RWE (GY: RWE) is its country's top power producer, and ranks among the top five European electricity and gas suppliers. Yet at €64.50 it sells on a p/e of just over nine. The 2010 prospective yield is 5.8%, which is forecast to reach 6% next year.

In Switzerland, global insurance provider Zurich Financial Services (VX: ZURN) is even cheaper. At Sfr269, it's on a multiple of below nine and a 6% yield. If you're looking for an even higher payout, France Telecom (FP: FTE) can provide it. This is the main telecoms firm in France and the third biggest in Europe. Yet at €17.90, it's currently yielding a tasty 7.9% and trading on a p/e of around ten.

In America, finding high dividend payouts is tougher. But the world's biggest drug maker, Pfizer (NYSE: PFE), looks good. With net cash on the balance sheet, and more flowing in, it's on a p/e below eight with a 4% yield. Integrated energy stock Conoco Philips (NYSE: COP) stands on a sub-nine multiple, while the prospective yield is 3.8%. Further north, top Canadian telecom firm BCE (TSX: BCE) looks cheap on a p/e of around 11.5. This year's yield is set to be 5.6%.

If you prefer to buy a fund rather than individual stocks, the Fidelity European Investment Trust (LSE: FEV) currently yields 4.2%. It's on a 15.5% discount to net asset value, which means you're buying £118 worth of assets for each £100 you invest.

Japan

Then there's our old favourite, Japan. As Goldman Sachs predicts, a weaker yen might be on the cards. But a weaker yen would be good news overall for Japanese stocks, and should drive the market higher. Given sterling's frail outlook, we'd expect any losses on the sterling/yen exchange rate to be outweighed by gains on the Japanese markets. Japan seems to have enjoyed a burst of mainstream popularity this year, and some of our investment trust picks of recent months have already jumped in value. But JPMorgan Japanese Investment Trust (LSE: JFJ) still trades on a discount of 15% and pays a dividend of 1.6%.

This article was originally published in MoneyWeek magazine issue number 478 on 19 March 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.