4) We can speculate endlessly about future events – political, economic and financial. Don’t bother. That’s where the crowd is looking. All we need to do is to focus on what the crowd is expecting, and we’ll know what’s already reflected in prices. What makes prices move is
CHAPTER FOUR
In the case of a Treasury bill*, the yield and the price are all one: T –bills are repaid at par 100 and issued at an appropriate discount so that the capital appreciation is the yield –the yield is in the price. The same kind of thing happens in currencies.
For example, you might be told that the pound (in June, say) is $2.00 for cash or “spot”*, $1.97 for September and $1.94 for December. These different prices reflect the difference in interest rates on sterling and on dollars, when sterling interest rates are higher. Why? Because if you want dollars in, say, 3 months time in exchange for pounds and want to pin down today’s exchange rate, you could either 1) buy them now for cash on the spot; or 2) buy them “forward*”, for settlementin3 months time. Option 2) must work out at exactly the same cost as option 1). Otherwise, Shell and Volkswagen and Citibank would arbitrage* the hell out of any difference. You can see that.
To spell out the arithmetic. Suppose 3-month sterling interest rates are 12% and 3-month dollar rates are 6% (i.e. sterling deposits return 1.5% a quarter more than dollar deposits, and sterling borrowings cost 1.5% a quarter more). If you (1) buy dollars now, you will get 1.5% interest over 3 months and forfeit the 3% that you would have earned on your pounds: you would only do that if you got 1.5% more dollars by buying now than by buying in 3 months time – which of course is just what you do get.
And if you 2) buy dollars 3 months forward you get 1.5% less than if you buy them for cash on the spot: obviously, because you still have your pounds which are earning you 3% a quarter, which is 1.5% more than you can earn on dollars. QED. This arithmetic is carved in stone.
If you bear this arithmetic in mind, you will never forget that interest rate differentials always have been and always will be lurking there at the heart of every currency parity: they are “in the price” in every forward and future transaction, just as the T-bill yield is “in the price” . Consequently
no trader in forward or futures markets can help being conscious over time of the interest rate differentials in the currencies they are trading. If you hold a currency with a strongly adverse differential, it gnaws away at your position, whittling down over time any profits you may be making and compounding losses. If it is a favourable differential it cumulates your profits, over time, and has a forgiving effect on losses. For example, assuming the interest rate structure cited above, if you are holding sterling against dollars, the value of your holding rises 1.5% a quarter with no change in the spot rate. Conversely, if you are short sterling against the dollar, you lose 1.5% a quarter with an unchanged spot rate.
In other words, interest rates – interest rate differentials – are
In fact, if you look at the charts in this book, you will see examples of currencies regularly moving in the opposite direction to interest rates –totally ignoring increasingly favourable, or increasingly unfavourable yield differentials. The truth is that in such cases, it is the currency that is the
In any case,
Now you may say: “Hang on. There are times when we definitely
The expectation of falling interest rates was, as they say, discounted. You could see the degree of the discounting in the interest rate markets them– selves, since interest rates in the future are quoted, for the next few quarters. At any time you looked at the structure of interest rate futures in 1990 or 1991 you would find they were expected to be whole points lower 3 and 6 months ahead. In 1990 these expectations were constantly being confounded. They either didn’t fall at all, or else when they did fall, they didn’t fall as fast as people expected.
If we cannot make useful forecasts of interest rates, and if, in any case, future interest rate movements are most unreliably related to currency movements, what should we do? The answer is that we should
You will have spotted that when interest rates are leading a currency, the key to their effect on the currency lies

can often gauge expectations. And if we work on the rule of thumb that expectations will be confounded, we shall be right much more often than wrong. If you spot a time when everyone is expecting US interest rates to fall, for example, buy the dollar, and you’ll make out OK. A few people did, all the way from 1980 to 1985– when US rates did indeed fall.
So the fortunate truth is: we don’t even
Once again, what we are looking for is the