Ditch the dollar for these two trading opportunities …

When we think of trading opportunities in the currency market our first question is usually: What’s the dollar doing?

From an analytical perspective, that’s the right question to ask first because the dollar is the world’s reserve currency and represents about two-thirds of exchange denomination among global central banks.

But when the dollar is acting like a dog, as it is now, it’s time to take the dollar out of the trading equation and look to cross-rate trading opportunities for action.

Why is the dollar a dog? And what are cross-rates? Good questions. I’ll explain. But let me give you a bit of perspective on just how deep the foreign exchange market (aka forex) really is …

It’s estimated there’s about $4 trillion dollars in daily forex transactions. That is massive! And it dwarfs that of stock and bond markets. And of that $4 trillion, about 80 percent of it is dominated in the six major dollar pairs: Euro-USD, USD-Japanese yen, British pound-USD, USD-Canadian dollar, Australian dollar-USD, and USD-Swiss franc.

Why So Much Activity
in Dollar Pairs?

It’s because countries must hold U.S. dollars in order to facilitate international trade and capital flows. The world’s major commodities are traded in dollars. For example, if you don’t produce oil domestically you will need to get ahold of dollars to buy oil on the world market.

So you can see why the dollar, despite its many warts, is the linchpin to the flow of goods and capital around the globe.

Now back to the dollar dog and why it’s time to look at cross-rates …

We can never evaluate a currency in isolation. When we say the dollar is weak, we have to answer the question: Weak against what other currency? The euro, pound, franc?

The primary benchmark for measuring the dollar is the U.S. dollar index. This index is a combination of six currencies: Euro (EUR), Japanese yen (JPY), Pound sterling (GBP), Canadian dollar (CAD), Swedish krona (SEK), and Swiss franc (CHF).

Looking at the dollar index in the chart below, you can see it has done nothing but go sideways in a 5.5 percent trading range for a long time. It has been about seventeen weeks since it made a low of 7270 back on May 4, 2011.

This usually means trading in the major dollar pairs can be a frustrating game. But you don’t have to just trade the dollar pairs; you can trade the cross-rate pairs instead …

A cross-rate trade is a fancy name for a currency trade, i.e. trading one currency against another that is not the U.S. dollar. In the spot forex market you can access the major traded cross-rate pairs directly. And the reason you would do that is because there may be lot more action.

In fact, in the two cross-rate trading ideas I like best, there has been action. And there are good reasons to believe there’s plenty of opportunity to make money.

Cross-Rate Trading Idea #1—
Short British pound/Canadian dollar

I’m expecting the Canadian dollar to gain in value relative to the British pound. This is a longer-term trade based on a disparity in the economic fundamentals of the two countries. Here are some basic fundamental rationales and the technical chart supporting this idea …

Canada may be slowing a bit, but it’s growing faster than the UK. And it appears the UK can tip into recession at any time.

Moreover, the UK’s major trading partners in the euro zone are heading straight for recession. Granted, the U.S. as Canada’s major trading partner isn’t setting any records. But on a relative basis the U.S. is better off than the euro zone. In addition, Canada has the bonus demand kicker from China, which the UK is lacking.

UK short-term interest rates are lower than those in Canada, giving Canada a yield advantage. And I believe the Bank of England will initiate another round of quantitative easing, increasing the yield advantage on the Canadian dollar deposits even more.

Some key points that appear in the chart below:

A failed test of the old highs with the price accelerating down and about to test the 22-day moving average, which has proved a good support/resistance level in the past.

In addition, the momentum oscillators are turning down from oversold and showed a divergence in the price high of the pair, i.e. when GBP/CAD made its recent price high the slow stochastic indicator at the bottom of the chart confirmed it.

Cross-Rate Trading Idea #2—
Long Australian dollar/Japanese yen

I’m also expecting the Australian dollar to increase in value relative to the Japanese yen. This is a much shorter-term trade setup that is based primarily on sentiment and technical analysis and will likely only be a “good” trade if the stock market stages a near-term rally.

This cross-rate pair is considered the premiere “risk asset” pair. That means when risk assets, i.e. stocks and commodities, rally this pair usually follows along … and a lot faster than most of the other dollar or cross-rate pairs. It’s why I said the stock market needs to stage a rebound, some type of short-term correction at least, for this trade to work as planned.

The outside kicker that could make this trade a huge winner is the ongoing possibility of intervention by the Bank of Japan (BOJ). The last time the BOJ stepped in and sold its own currency, the AUD/JPY pair soared.

Let’s take a look at the technical setup below …

You can see in the chart where I have labeled the last time the Bank of Japan intervened back on March 17; it was zoom-zoom in the AUD/JPY. This pair is working higher nicely now and about to test some strong resistance near 81.20. The most recent high comes into play there, and the 22-day moving average is also around that level.

I have been expecting some type of short-term bounce in stocks from an extreme oversold position. If that doesn’t materialize and the Bank of Japan doesn’t intervene, this trade won’t work. But trading is about knowing your reasons and controlling your risk.

I think the reasons I just gave you make sense. Therefore, the risk-reward profile on this trade appears excellent.

The number of potential cross-rate opportunities in the currency market is vast. The number of ideas is only limited by our imagination. In upcoming issues of Money and Markets I will show you how you can apply these same principles even if you use currency ETFs or currency options as your means to accessing the powerful forex market.

Thank you and have a great weekend.

Jack

P.S. One important point to keep in mind as you look again at the U.S. dollar index chart: Once the dollar index breaks out of that long range, one way or the other, it may be the perfect time to jump back on the dollar-paired trades and ride them. Stay tuned for my signal.