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Categorizing forex pairs is a difficult task because so many factors affect each currency pair. It seems it is much easier to categorize other investments. For instance, if you are interested in higher yields and can tolerate high risk, there are bonds and small cap stocks that fit that description neatly. If you are interested in technology companies or environmentally “green” companies, there are convenient ways to find equities or private investments that fit those categories. Putting forex pairs into similar categories is much more difficult.

Currencies reflect the performance and policies of entire economies, sovereign governments and industry. The blend of factors that can affect a currency change everyday.

Because of this unusual situation and the fact that there are relatively few currency pairs available to trade, two myths have arisen.

Myth #1 – Trading currency is easier because fewer pairs means it is easier to find trades

We hear this one at seminars and other sales pitches all the time. It is not true. The financial markets have a remarkable equilibrium. If risk levels are low, expected returns are typically low. If risk levels are high, expected returns are typically higher. Any experienced trader will tell you that having fewer choices presents some unique hardships. For example, it is more difficult to diversify because many of the available pairs are correlated, and there isn’t much variation in risk levels.

Myth #2 – Currencies fall into discrete categories and can be used as replacements for other asset classes

Traders are trapped by this myth when they begin evaluating a currency as though only one or two factors can affect its value. For example, some traders may assume that the only factor influencing the Canadian dollar (CAD) is oil price, or that interest rates exclusively push the U.S. dollar (USD).

To be clear, there is a lot of valuable information that can be gathered by looking at the intermarket environment, and certainly some factors do exhibit enormous influence over different currencies. But these groups or categories will overlap and are not exclusive. Plus, they do not always behave in ways that related asset classes would.

Currency Characteristics and Categories

There are convenient ways to understand what might influence a forex pair and to understand its relationship to other currencies.

Any economist will tell you there are three things that affect exchange rates:

- International trade
- Capital flows into investments like stocks and bonds
- Purchases of assets like factories, real property or machinery located in another country

We usually ignore the third factor because it is such a small part of the forex. All the other news you see everyday is only important because it is the information that traders use to forecast changes in those primary forces and expected movements in exchange rates.

These factors provide context for identifying what will affect a currency. For example, if yields (returns from bonds and other investments) are extremely high in a particular economy compared to others, those yields affect capital flows and will be a major factor in the currency exchange rate. This also means that those currencies will be very sensitive to any changes in the credit market, interest rates or yields. It may even overshadow other historically dominant factors, like exports.

For our purposes, we divide currencies into two groups and cross them with the U.S. dollar (USD) as a common denominator. The first group, the International Trade Currencies, are those currency pairs that historically have been most influenced by trade issues.

The second group, the Capital Flow Currencies, are those currency pairs that historically have been most affected by changes in capital flows (money flowing in and out of an economy). Keep in mind that there is a lot of overlap in these two currency-pair groupings, and since yields can change over time, the emphasis you place on one factor over another may shift.

International trade currencies: These currencies are heavily influenced by changes in global demand for raw materials (commodities) and finished goods. A few of them—the Canadian dollar (CAD), the Australian dollar (AUD) and the New Zealand dollar (NZD)—are often referred to as the “commodity currencies.” Currently, the Australian dollar (AUD) and the New Zealand dollar (NZD) also have very high target interest rates in their economies and are therefore also very sensitive to changes in the forces behind capital flows, such as interest rates, the credit market and yields.

Capital flow currencies: These currencies are heavily influenced by changes in demand for investments including equities, bonds and interest bearing investments. The U.S. dollar (USD), the euro (EUR), the British pound (GBP) and the Swiss franc (CHF) are the primary capital-flow currencies because the markets represented by these currencies have the strongest and most active banking and financial sectors in the world.

How to Use This Model in Your Trading

Here is a great example of how you can use an understanding of currency characteristics in your trading. Not too long ago, the median target interest rate among the Central banks represented by the major currencies was four percent. The outlier on the high side was Australia with an interest rate over six percent. This meant that the Australian dollar (AUD) was extremely sensitive to trade issues as well as anything that might have affected capital flows. The small blue arrows on the chart show whether Australia’s trade numbers improved or declined. You should be able to see a very high correlation with the subsequent movement in the currency pair. However, the real price shocks were associated with disruptions in the credit market. As an interest rate leader, the Australian dollar (AUD) was very sensitive to these changes.

Affect of Trade on Australian dollar (AUD)

Knowing what may impact the prices of a currency pair is vital to a forex trader. It’s like a racecar driver who needs to understand speed, inertia and the forces exerted on the tires.

Let’s take a look at a few tips you can use for determining what may or may not move the price of a currency pair:

1. Don’t become overexposed to currencies with similar characteristics. Investing long in the EUR/USD and short in the USD/CHF is like putting all of your money in one currency pair or the other because both currency pairs are affected by many of the same fundamental factors.

2. Plan for the risk factors that could affect your trades the most. For instance, trade numbers in the U.S. will probably not affect the EUR/USD as much as a breakout in yields would so probably want to pay more attention to yields when investing in the EUR/USD.

3. Don’t focus too much on any one fundamental factor when evaluating a currency pair. Currency pair prices are sensitive to many factors, and those factors change over time. Manage your risk control to account for those issues. Keep in mind that differences in these influences from one economy to the next are as important as the factors themselves.

4. Diversify and minimize risk by looking for a nice blend of currency pairs that are each influenced differently by the fundamental factors we have discussed here.

Make sure to watch the video above, and then continue to Earning Interest in a Forex Account