What are the best bets in forex now?

When it comes to currency trading, it is perception rather than the true economic situation which matters most. Analyst Paul Rodriguez reveals the key trends that are driving the forex markets right now.

Let's be upfront here most currency trading is speculative. It often doesn't matter what the true economic situation is it's how it's perceived that matters. The trouble is that perceptions can be remarkably fickle, which means the flow of so-called hot' money that drives currencies higher can rapidly reverse when opinions change. So what's driving markets just now?

With low volatility in both stock and currency markets, the main thing driving FX markets is the difference in interest rates between countries, or yield spreads'. Economies with high nominal interest rates and solid growth, such as Australia, have seen their currencies appreciate strongly. But markets remain worried about inflation, with rising commodity prices and emerging market demand threatening to drive prices higher across the globe. What does all this mean for the major currencies?

The US dollar

The US economy has been hit by a stalling housing market and the fear that this could hit the consumer. As pessimism built up earlier this year, the market priced in the risk of sharp interest-rate cuts, prompting broad-based US dollar weakness. The sell-off became overdone and so a rebound was inevitable. But even so, the dollar's longer-term prospects look weak and a return to $2.00 and above against sterling is certainly possible.

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Those who disagree cite the rising US stockmarket as an indication of a healthy economy. But stockmarkets can also rise during inflationary periods until they reach a tipping-point, which could mean the equity market surge is in fact just a speculative bubble. The acid test is the US market's ability to absorb higher interest rates. But although higher rates may be the medicine the US economy needs, the risk of making the fragile housing market worse makes this a difficult decision for the Federal Reserve to make. If you believe the US economy is stronger than most believe, there is upside potential for the dollar. From a technical perspective, $1.96 represents a good support for sterling against the US dollar and a break below that would see the dollar bears running for cover. But I believe that after some consolidation, the US currency will resume its downward trend.

The Japanese yen

Much has been made of the weakness of the US dollar, mainly because it hit the key $2.00 mark against sterling. But the Japanese yen has actually been losing ground, even to the falling greenback.

The ability to borrow cheaply' in yen (Japanese interest rates are still just 0.5%) has seen both domestic and international investors sell the currency to invest in higher-yielding investments overseas.

This is risky, as the currency markets can turn rapidly, but with volatility low, investors are unconcerned. Meanwhile, Japan's economy has been under-performing, so even the prospect of modest tightening in the next six months is unlikely to see a reversal in the yen's fortunes. Even against a weak dollar, the yen looks set to slide towards 125, so against a bullish sterling, multi-year highs over 245 look likely.

The euro

Solid economic growth and tighter monetary policy have seen the euro advance strongly beyond what could be considered fair value'. Despite the broadening of the euro area to include 27 members, the market continues to view the expansion of the free trade area as a positive, not least as the majority of the new members are moving fairly quickly to try to become full EMU members. And while new members in Eastern Europe such as Poland or the Czech Republic are attempting to join the founding members of the euro, there's an opportunity for speculative investors to build ongoing convergence trades'.

The currencies of these potential EMU members have risen in their own right against the US Dollar and Euro, given the potential for growth and gains from monetary discipline. But they are less liquid than the 'majors' and their wider spreads make day-to-day speculation a little more challenging. A strategy could be to consider them long term plays with considerable scope for growth. If you are a really far-sighted investor, how about buying Turkish Lira and selling Japanese Yen? For shorter-term trading, the euro/US dollar is the most liquid.

In the short term, EUR/USD has momentum for a move towards $1.3300 as the dollar rebounds, but the potential for longer-term dollar weakness should then come to bear. Over the coming months, a return to $1.36 and beyond is possible; only a two-week close below technical support of $1.3250 would indicate a change in trend. The euro may be a better buy against the yen with targets towards 170. Only a two-week close below 160 would indicate a change in trend on this.

The pound sterling

The need for higher interest rates to cool a dizzy UK housing market has helped sterling and explains the recent test of $2.01 against the dollar. But can the situation continue? It is likely that our housing market is a bubble and the delayed impact of rising rates could bite any moment. Sterling has started to wobble and $1.96 beckons against the dollar. If this gains momentum, sterling could be pressured back towards $1.90. However, $1.96 is a key technical barrier, and the US economy may be at even more risk. So a resumption of the trend towards $2.00 and up seems more likely.

The Swiss franc

The Swiss franc, known for its safe haven status, has been shunned of late in favour of higher-yielding trades. It looks set to remain weak against the euro and sterling and may only manage to gain against the yen.

The commodity currencies

The so-called commodity currencies have done well in the current environment and are worth a look. These are the currencies of countries with large supplies of natural resources for which there is great global demand. For example, the Canadian dollar is very strong and seen as a buy against a wide range of currencies. It has also benefited from the market re-pricing its interest rate outlook from cuts to potential hikes. Against the US dollar a move to $1.00 (currently $1.08) is possible long term. The Australian dollar and New Zealand dollar also remain good long bets in the face of rising commodity prices, but caution should be applied if commodities take a breather.

Paul Rodriguez is technical analyst and managing director of ThinkTrading.com, which trains professional traders to use charts for profit.