The Way of the Dollar

PREFACE

To the Web Edition – year 2000

It’s about ten years since I started writing The Way of the Dollar . Reissuing it for the web has been a curiously time-consuming endeavour – for mainly technical reasons – even though I decided to reproduce it in its original form rather than in a revised edition. But of course times have changed.

Currency Bulletin’s methodology was settled in the mid-1980s and has remained fundamentally unchanged ever since. Up front, it has to be said that the currency markets have become highly ‘efficient’, by which we mean that the supposed price-sensitive information is effectively discounted in prices so that attempts to anticipate price movements in the major dollar parities on the basis of such information have, over time , tended to be no more successful than a pin. This concept sounds easy to grasp, but in practice people have great difficulty with it: even if they see it must apply in general, there often seem to be good reasons why it doesn’t apply in a particular case (where we think we have a special angle on the data; where we think it may not yet be discounted). CB simply accepts that it is a waste of time. The approach adopted by CB and set out in TwotD was to look elsewhere to an area of inefficiency in currency pricing which seemed to be consistently reliable.

The analysts out there are looking for the explanation for currency movement in future events – such as interest rate changes; or central bank actions; or shifts in economic growth. The degree to which any event is discounted in price and the scope for insight or inside knowledge in such areas is small, and not too susceptible to systematic study. In this, currencies differ from stocks, for example, where expertise can be acquired in the way of specialised knowledge of individual company affairs: ditto with certain commodities, I imagine.

The alternative is to concentrate on determining what it is that the crowd is expecting, which is what is already discounted in prices, and on evaluating the degree of the crowd’s commitment. CB’s theory is that this is where the most reliable inefficiencies in the currency markets are generated, when the crowd gets over-committed to a view of the future. And the degree of over-commitment can be gauged in various indicators

of sentiment among currency observers and participants – the level of speculation and consensus, in particular.

Three basic assumptions were that 1) the crowd tended to lose money; 2) that it tended to be ‘right for the trends but wrong at both ends’; and 3) that therefore it would pay to go contrary to the crowd at the ‘ends’ or price extremes. None of the above was too contentious, but the assumptions take you nowhere unless you have a way of locating the price extremes. The formula CB settled on was to define the extremes, not in terms of price but in terms of sentiment . The underlying equation was: a price extreme = an extreme of consensus + an extreme of speculation.

Naturally you can, at any moment, point to some other driving force like a divergence or convergence in growth rates; or a rising or falling stock market; or a shift in central bank policy, via intervention or interest rates. Recently, observers have put the finger on equity and direct investment flows. Any of these can be or seem to be the determinants of currency movements. CB’s contention was that this might be so, but that you were more likely to lose money following such episodic rationales than following a consistent contrarian, sentiment-based approach, which was founded on human nature. And it worked.

In two decades, there were a few periods when the ebb and flow of sentiment was distorted or overwhelmed by unpredictable forces. In the mid-1990s, the automated trading systems were disrupted by a series of ‘stop-loss-cascade’ moves that looked to have been triggered by other market participants. These movements were sufficiently violent to upset most methodical traders (including CB) but they nicely illustrated the critical weight of ‘set-up conditions’ – speculative positioning particularly – as an engine of price movement. The moment passed. Then in the second half of the 90s came the thundering horde of macro hedge funds, throwing many tens of billions at the Yen carry trade (and dollar/DM). The disruption here was that the flows self-fed to an unprecedented degree as the size of the forex-active hedge money mushroomed – meaning that the extremes that CB gauges got that much more extreme. That moment passed too. Hedge money has retired hurt from the currency markets, leaving them much slimmer.

The point about sentiment is that it’s always there, always at work, and always offering an edge to exponents who have been able to keep their finger on the pulse of sentiment (and this applies to all financial markets, and always has). The rationales that participants use to justify their expectations and positions are simply the raw material underlying the ebbs 4 and flows in sentiment. We cannot use them, but keeping up with them is

part of the business of keeping one’s finger on the pulse. In this respect, nothing has changed since TwotD was first published in 1991.

Has the existence of the book, and the fortnightly appearance of Currency Bulletin for nearly 20 years – has this exposure of a successful methodology to the public gaze changed the odds and blunted our edge when it comes to trading? Certainly, there is much more awareness of the relevance of positioning and consensus in currency fluctuations, regardless of CB’s contribution to the matter. I just don’t know whether we have lost some of our initial edge. I see the approach working a treat all round. In the broad sweep of the dollar and the euro and in their minor mood changes; in the twists and turns in the commonwealth dollars; in the fluctuations in euro/SF; in the fashion shifts in sterling.

Which leaves the adaptations we need to make for more widespread awareness of sentiment out there. Most investment banks now make some attempt at tracking clients’ positions. At least two banks, Deutsche Bank and the Dutch bank ABN-Amro publicise their research in the area in the sense of allowing the media some access to it. As far as I know, Deutsche Bank does the most comprehensive work in this area – and very good it is too. When it comes to coverage of forex exposures, the danger is that the more comprehensive you aim to be, the greater the danger of producing a soup with no information. For every buyer there has to be a seller after all. CB’s aim has always been to concentrate on the speculative segment. To this day this is most purely represented in the IMM open interest.

Deutsche Bank has added a valuable nugget however. CB prides itself on being able to read and interpret the bare IMM OI figures in the context of price movement: they have the huge advantage of being available daily (at about 1.00 pm London-time) for the previous day. We have never been able to make good use of the weekly figures produced by the CFTC for the commitments of traders – at least until DB came along and charted the series. That showed that the figures seemed to successfully separate out the speculators from the specialists and pros, thus giving a good picture of net speculative exposures. As noted this is only on a weekly basis and 5 days late, but it gives an interesting check on our subjective interpretation. Just for instance, the weekly series showed net speculation significantly long of euro during its July-August decline, which is something we could not necessarily have gleaned from the raw daily OI figs.

Amazingly, for the rest we’re back where we stood in 1991. The consensus gauges were never something we placed much reliance in: they needed to be confirmed by anecdotal evidence from market gossip. The “perception of the trend” (TwotD page 50) has been refined into a price target gauge, in

the light of the recurrent phenomenon, as the consensus hardens, on the direction of the trend – that price targets get extended further out: an intuitive indicator, this. The “reaction to news” gauge is as valid as ever – no more no less – being used as confirmatory indicator of a trend that is in the process of changing.

What about the introduction of the single currency to replace the nine currencies of EMU ? important as it is, it hasn’t changed any part of CB’s methodology, which has always been based first and foremost on the main dollar parities. As far as they are concerned the euro has replaced the D-Mark, and that’s that. The weight of the euro, however, has created a new major parity in the shape of euro/Yen – and some minor parities of more significance than their DM cross rates had, like euro/sterling and euro/ SF. The result has been to complicate the analysis