The Way of the Dollar

rules which seem to govern the relationship between interest rate shifts and currency movements.

1) Interest rate shifts prompted by domestic pressures (an over-heating economy, for example) tend to lead currency movements. The lead time is measured in months rather than days (e.g. the rise in the DM and SF in late 1989, and the dollar in 1981-5).

2) Interest rate shifts prompted by international (and currency) pressures tend to follow currency movements and go in the opposite direction ( e.g. the Yen in 1989, and the pound in 1988-9).

3) Following rule 2), a currency will tend to turn round and follow the lead of interest rates up: a) if/when they have risen around 4 points and especially, b) when the currency is perceived to have stabilised over several months (e.g. sterling in Spring 1985, and in 1990).

4) In this event, interest rates will peak when the currency troughs; and falling interest rates will coincide with a rising currency. Why? Because by this time everyone is expecting interest rates to fall tomorrow and they stay up longer than expected –i.e. rate cuts tend to lag expectations in these circumstances (e.g. Pound, Can $ and Aus $ in 1990-91). In other words, interest rates are higher than expected and this supports the currency.

5) When currencies are led by interest rates, their movement is directly related to the unexpectedness of interest rate levels, rather than to their rate of change (e.g. $ in 1983 -4, pound and SF in 1990).

Rule 4) is an exception to rule 1) and there are others. For example falling interest yields call for rising bond prices. The result, in the case of the major investment currencies, can be a tug-of-war, when falling interest rates might discourage international investors but rising bond prices attract them –as they did in the case of the dollar in summer 1984 to spring 1985.Finally rules) is a cardinal rule. It is often the acid test of whether any given interest rate will lead a currency: it only does so when unexpected or unseen. When observers are ignoring an important shift in interest rates for any reason –because they expected it to be short-lived or because they are preoccupied with other things –you can bet it will only be a matter of time before the currency is led inexorably in the direction of the interest rate shift. What matters, as I say, is the background, not the foreground –because the foreground is where everyone is looking. What matters in financial markets –and in life? –is not what you see straight ahead but what you glimpse out of the corner of your eye.

Inflation and Real Yields’*

There is another exception to rule 1). If US interest rates are being pushed up because of a perception that US inflation is headed up, or if they fall because inflation is seen to be falling, you have another tug 0' war,between the short time-frame and the longer time-frame. To short-termers, higher rates may seem to support a currency: but over time, inflation corrupts a currency. So a movement in interest rates that is led by inflation is suspect: “real” interest rates may be unaffected, or even moving in the opposite direction.

This idea of real, inflation-adjusted interest rates may sometimes seem a bit academic. And indeed it’s a hybrid invention, for its two constituents occupy different time-frames. Interest rates can fluctuate violently over the short term: inflation can have big swings measured in years. But inflation is the one and only sufficient modulator of a currency’s value over time –any currency. Given sufficient time and/or a sufficient divergence in inflation rates, currencies do and probably must tend inexorably to follow inflation differentials in due course. We can see it happen before our eyes with the hyper-inflationary currencies: for the reserve* currencies, with their smaller inflation differentials, it’s a bit like watching plants grow.

Just as we can adjust interest for inflation to get at something closer to

the “real” picture, so we can do the same thing for currencies. It’s another academic exercise. And it’s very difficult to see how we can use “real” inflation-adjusted currency histories for any practical purpose. But it may at times be helpful for perspective. It’s difficult, for example, to look at these charts of the “real” dollar without leaping to the conclusion that the big bull market in the dollar in 1981-5 was a strange aberration in the long-term picture. In this light, the slump in the dollar from 1985 to 1987 is seen merely as a return to normal.

Although “real” yields are a hybrid, the constituents are, as it were, incestuously related. For inflation expectations are a major determinant of interest rates over time; in fact they area key determinant of long term yields all the time. Hence, the declining trend in US inflation provided as good (or better) an account of the bull market in the dollar in 1981-5 as real long-term yields.

In short, yield differentials and inflation differentials seem to be basic fundamentals of currency analysis.

As we know, the thing that makes prices move is change. And it’s axiomatic with all financial instruments that the change in question is change in expected total return. In the case of commodities, expected total return is confined to price; and the value benchmarks are usually concerned with supply and demand. In the case of bonds, total return to maturity is interest coupons plus (or minus) the difference between price and redemption value – usually “par”*: if you expect to sell before maturity, redemption value is unknown; either way, the value benchmarks are yield and the degree of certainty that interest and principal will be duly paid. Stocks fall in between: most investors nowadays focus on price, with dividend returns counting for little: still the main value benchmark is usually earning power, or the ability to payout dividends in the future.

In currencies, changes in real yield differentials are a basic value bencmark.

And I think this has been true ever since currencies began to float freely in 1973. Admittedly the professionals didn’t quite see it that way in the old days. But while we’re at it, we might as well blow their secret. The professionals made a bundle of money in the 1970s, and the way they made it was very simple. They only had two rules. One has been valid as far back as the memories of currency traders went: “sell the crisis. “When a currency got into trouble, all you needed to do was wait until the central bank came in to support it and then sell for all you were worth. It always worked: for sterling, the lira, French franc, whatever. The other rule, when the dollar went off the gold standard, was even simpler: “sell the dollar”.

Always, but especially if the central banks supported it. Following these two rules, the professional! cleaned up and the central banks lost a bundle.

In the 1980s, the roles were reversed and it was the central banks that cleaned up, with much loss of shirts among the professionals. Part of the trouble was that traders were introducing all sorts of complications into the currency equation to do with intrinsic values, and trade competitiveness; and they were obsessed with forecasting interest rates.

We know that expected total return has to be the ultimate value bench. mark for the currencies. If we know how to judge the set-up conditions tha1 precede significant moves in the dollar, and how to evaluate the back. ground of shifts in real yield differentials, we shall usually be able to spot the underlying trend in the dollar .

CHAPTER FIVE