Think of this image when you are trading the financial markets. Why is an arm wrestle an important image to help with your trading? Well, this idea underpins currency trading.
Here is the explanation:
In trading currencies, we always want to trade a strong currency against a weak currency. We don’t want to trade strong currencies with other strong currencies or weak currencies with other weak currencies. No, because that will often result in very rangebound action. Instead, look to trade strong currencies against weak currencies.
How to tell which currencies are weak and strong
The key to understanding currency strength and weakness is a skill that can be taught. It takes time to learn. However, a good start is to understand the impact interest rates have on currency weakness and strength. In simple terms, you need to realise that currencies are strongly moved by their interest rates, especially in the short term. If interest rates are expected to rise, then the currency appreciates and bond yields rise. If interest rates are expected to fall then the currency depreciates and bond yields fall.
So look to trade currencies whose central banks are indicating that they look like rising interest rates. That is your strong currency. Then pair that with a currency whose central bank is, if not actively looking to cut rates, then at least on hold. That will be your weak currency.
A recent example
On April 21 the Bank of Canada made a hawkish shift. Bond purchases were reduced by $1 billion per week to $3 billion. The BoC became the first central bank to signal that it will be exiting its stimulus package. This was a tailwind for CAD and your ‘strong currency’.
Around the same time, the Federal Reserve was maintaining its bearish bias. This made the USD a perfect counterpart to trade the CAD with. The weak currency.
You can read the post published at the time on BoC hawkish shift and see how the process worked.