Nowadays, the cryptocurrency market has become one of the most discussed topics…
Types of currencies: which to choose?
Depending on the economic situation, investors choose where to invest their money and which currency to buy. So how do they make their decision? Which factors make them buy one currency instead of another one? Let’s look at the main types of currencies and define how they differ.
Reserve or safe-haven currencies are currencies that tend to strengthen during the periods of uncertainty and fear at the market when investors want to find a safe place for their savings. In other words, they are used when the market is in the state of risk aversion.
Such currencies belong to countries with political and economic stability, low inflation rate and balance of payments surplus. As the time goes by, different currencies play the role of the refuge ones. For now, such currencies are the US dollar, the Japanese yen, and the Swiss franc.
Let’s look at them.
The US dollar is the most famous and widely traded reserve currency. It played this role even since the Bretton Woods conference in 1945. During the last decade, more than 60% of the world’s foreign exchange reserves were held in the US dollar. All things equal, the greenback tends to appreciate during economic instability when investors exchange their currencies for the dollar. Investors see the USD as a reliable and safe currency. Positive news on the economic growth and labor market support the currency growth as well.
The Japanese yen is another reserve currency that attracts a lot of investors. It is interesting that the yen rises even when negative news from Japan come. It happens because Japanese investors return their money from abroad to the domestic market (a process known as repatriation). Cross-currency pairs as AUD/JPY, NZD/JPY, CAD/JPY are highly traded and negative news in the commodity market lead to the increase of the yen.
The Swiss franc became the reserve currency because of the political neutrality of Switzerland and the attractive bank sector. During the euro zone’s debt crisis of 2010-2012, the demand for the franc was high.
To sum up, we can say that reserve currencies are used more during unstable economic situations when investors need to preserve their savings.
Commodity currencies are the currencies of economies with the large share of production and export of natural resources like oil, gas, coal, precious metals, etc.
The Canadian, Australian and New Zealand dollar, Russian rubble and Norwegian crone are among commodity currencies. However, most commodity currencies are regulated by governments and not traded on the market enough. That is why only three currencies are highly used in the international market: the Canadian, the Australian and the New Zealand dollar. They are liquid and freely floating.
The peculiar feature of these currencies is that it is highly influenced by the dynamics of exports and economic growth of a country. So risk sentiment improves. For example, the demand rises when the world economy is stable and the exchange rates of these currencies rise. However, as soon as it suffers, commodity currencies fall.
A little bit more detailed explanation. When the world economy rises, the demand for commodities increases, so it leads to the growth of a country’s profit. Interest rates increase. It attracts foreign investors to the country within carry trade strategy.
Carry trade is a strategy when investors borrow money in currencies with the low rate of return and invest them in high-yielding currencies. The high rate of return correlates with high risks. Carry trade may support the rise of commodity currencies. However, if the situation turns around, and financial conditions get worse, it will lead to the capital outflow and the fall of a commodity currency.
How it works?
For instance, when the Australian or New Zealand’s interest rates are higher than in other countries such as Japan, investors might sell the yen and purchase the Australian or the New Zealand dollar. It will drive the Aussie or the Kiwi up. When market volatility happens or the growth of interest rates slows down, investors will close their positions and commodity currencies will depreciate.
Let’s look at the three main countries with the commodity currencies.
Canada is famous for its oil and gas resources. So the Canadian dollar highly depends on oil and gas prices. When the crude price rises, the Canadian dollar appreciates. At the same time, the Canadian economy is linked to the US economy. The USA is the main importer of Canadian commodities. So, the weak US economy can cause the decline of Canadian exports and the fall of the domestic currency.
Australia exports natural resources. The Chinese economy has a huge influence on the Australian dollar because it is the biggest importer of the Australian commodities. When Chinese economic figures are positive, the Australian dollar appreciates against the US one and vice versa.
New Zealand export is based on agricultural sector: dairy products, meat, wood, and wool. The currency is affected by figures of dairy auctions, for example, the Global Dairy Trade. Moreover, the New Zealand economy is correlated with the Australian economy.
So when traders want to trade commodity currencies, they should follow the trend in commodity prices. However, they should take into account that commodity currencies have high risks.
Making a conclusion, we can say that traders always should take into account the economic situation that correlates with currency rates. When the world economy is stable and grows, traders can get a high profit by trading commodity currencies. However, during the economic instability, they should choose another type of currency – refuge – to keep their savings.