Page 55 - Ultimate Guide to Currency Trading

This system of currency management was called the Bretton Woods Agreement, and came out
of the aftermath of the heavy indebtedness caused by countries entering and fighting in World War II.
The system was locked in place, and worked for some time until it became apparent that more gold
was flowing out of the U.S. treasury than was flowing in. In fact, gold was flowing out at such a fast
rate that on August 15, 1971, the President of the United States, Richard Nixon, effectively stopped
the U.S. dollar/gold standard by halting all convertibility of U.S. dollars into gold, and therefore halting
all shipments of gold out of the U.S. reserves.

The Floating-Rate Mechanism and Currency Trading

After the closing of the gold window by Nixon and the breakdown of the Bret-ton Woods Agreement,
the world's main currencies began to move against each other based only upon supply and demand.
This unmanaged (or only slightly managed) system is called the floating rate system. This means that
the exchange rates between currencies and currency pair prices are not set by central banks. The
central bankers of the home countries might have a target amount that they would like the currency
to trade at; however, central banks that use the floating rate system usually do not put forces into
motion to change the current market determined exchange rate.

This means that the exchange rate between the AUD and the NZD will be determined by
currency markets alone, as well as demand for the goods and services between Australia and New
Zealand. The same goes true for Europe, the United States, and most other countries. Most of the
time, the market forces, supply, demand, and trade factors between the two countries will determine
the market price for the EUR/USD pair, and other Forex pairs.

Sometimes a central bank will buy and sell its own currency in the FX market to change the
price of its currency relative to a trading partner. This type of buying and selling was happening in
Switzerland in late 2010 up until mid-2011. The Swiss National Bank was using its reserves to buy up
massive quantities of euros in the open market. It also entered into derivative agreements such as
repos and reverse repos to cool the price of its franc. The franc at the time was gaining nearly every
week against the euro, mainly because of the worsening sovereign debt situation in Greece and other
euro-bloc countries. At the time, FX traders looked at other safe, low-yielding currencies such as the
JPY and the USD, but these too seemed as if they were not very good alternatives. Consequently the
Swiss franc became the ultimate safe-haven currency, and was even touted as being safe as paper
gold by some news sources.

Safe-haven currencies are usually the lowest-yielding currencies in the world. The idea
is that the lower yield of the currency usually equates to a lower price in the market.
To carry the idea further, if the currency is already lower priced, it has less room to fall
Essential
against other higher yielding currencies.