The Way of the Dollar

When real interest rates went negative, as they did in the 1970s, gold became relatively attractive, and the price soared against all currencies. At the start of the 1980s, real interest rates on the dollar went positive (very), and the price of gold collapsed –and not just in dollar terms. This may seem obvious, but it doesn’t seem to have got through to followers of gold. It’s not an academic point. So long as high real interest rates endure, and are expected to endure, the price of gold will wallow; and the total return on currency will exceed that on gold by at least the real interest rate. In these circumstances, which prevail foreseeably, gold has no interest as an investment.

Money does, because it offers a real interest return. How much return depends on the currency. And as with gold, shifts in real interest rates on individual currencies tend to be reflected in currency rates, producing enormous fluctuations as we all know –meaning enormous profits and enormous losses.

As a matter of fact, the recent history of currency markets has encouraged the view that the currencies – that means the dollar – move in huge trends, so that all you have to do is to catch onto some such trend and go with it for a couple of years until it’s obviously time to change and ride the trend in the reverse direction. Such an approach is doomed to extinction for precisely the same reasons as the equity cult is doomed to extinction: that as soon as everyone thinks this way, the trends will end in self-destruction.

No, let’s face it. The currency markets are not for those who love fantasy and self-delusion. They are, in fact, the quintessence of the ‘zero-sum* game’. In stock markets, when prices rise and fall, the wealth of all the participants taken together rises and falls too. Individuals can try and manoeuvre in and out, but the equity investment fraternity as a whole is subject to the whim of overall price trends. Fluctuations in the currency markets by contrast have no effect on the wealth of participants taken as a whole. A “fall” in the dollar is just another way of talking about a rise in the DM, Yen, pound etc. The overall wealth cannot be changed. We’re on our own.

The good news is that this means we are entirely in charge of our own destiny. For those who believe that trouble may lie ahead in the equity markets, the news is even better. Currency players are crash- proof. There is no such thing as a crash which wipes out wealth in the currency markets. No Meltdown Mondays. No Panic Fridays. Do the many fat years we have seen in stock markets mean seven lean years ahead? Who knows? But then again, who cares? Not currency traders.

Of course we care about being on the right side of the big movements in the dollar. The next chapter takes a look at the history of the currency markets and at the reasons for thinking they are “inefficient” and can be forecast. The subsequent four chapters consider how the currencies can be forecast –and how they can’t, for there are hosts of myths about currency forecasting. And the rest of the book, chapters 7 to 11, is concerned with turning forecasts into practical trading for profit. But first we must consider two ‘mind-traps’.

The “base-currency” mind-trap

The fact that currencies are money –the money of different countries – causes a problem with most newcomers to currency markets. A UK resident, for example, will say: “I thought I should protect myself against a fall in the pound, so I switched a Ј100,000 deposit into D-Marks. Should I be holding Yen?” The truth is that if you area UK resident with all your expenditure and liabilities in sterling, there is no reason why you should hold any other currency. Or rather the only reason why you should switch sterling into another currency – say D-Marks – is that you think the best probability in the financial universe is that the D-Mark will rise against the pound.

There are two points here. The first is that you cannot decrease your risk by selling your own currency and buying another one (unless you have a liability in that currency): that increases your risk. The second is that the markets offer a number of bets, but it’s relatively rare that the best of them

is that X currency will rise against the pound –or any other specific nondollar currency. The way it is in real life is that the dollar is the currency against which all others are quoted; and there is a firmament of currencies that bounce around the dollar in their own ways. That’s why this book is called “The Way of the Dollar”. .Thus the relationship between the nondollar currencies is a residual of the basic dollar relationship. And the residual is not easy to analyse or forecast.

A professor of agriculture was questioned at a seminar: “Sir, I have 200 acres in East Anglia; what do you advise me to do?”. “Sow it down to barley and find a job” came the blunt reply. We are all obsessed by our own situation and think the world must have answers to it. But the answers are often nothing to do with our specific situations. Financial markets, in particular, know nothing about our own situations – and don’t care.

Looking at the currency universe from the point of view of your own currency (unless it’s the dollar) is a mind-trap. It happens because people think of their own currency as money and other currencies as something else: as an investment, for example, or as something they need for a specific purpose– to buy foreign goods, say. You may hear a UK investor say that he is selling all his shares and putting his money in D-Marks. It would not occur to him that he wasbuying sterling with the shares he sold: that doesn’t make sense. In the same way, it does not occur to him that he is selling sterling to buy D-Marks. If it did, he might also ask himself whether sterling was the best currency to sell in order to buy D-Marks.

In other words, people who are not too familiar with currency markets are not always aware that a currency transaction is unlike any other kind of transaction: it involves a sale and a purchase by the same person: you can’t buy a currency without selling another. But if that person only gives thought to the currency being bought, and assumes that the only currency they can sell is their own, what chance have they of getting it right against full-timers in a market which turns over $600bn a day. They have one hand tied behind their back in a battle with sharks. .

When you’ve escaped from this mind-trap, then you see that what you have out there is no more than a series of price relationships – like commodity prices. If you have a forecasting system, as Currency Bulletin has, you will find it throws up a number of probabilities. The name of the game being performance, you want to bet on the best of these probabilities. Where do they lie?

Forwards and Futures.

Well, to start with, the US dollar is the currency against which all others are traded. Things are changing and may change

further. Banks are beginning to trade the non-dollar cross rates* directly: so is Chicago’s IMM* futures* market. And we may find over time that more good bets arise among the cross-rates* .Meanwhile the only hard data about currency dealings that exists, including some very valuable data, is to be found in the IMM, where the leading currencies are traded against the dollar.

On an average day, the IMM will turn over about $12bn; and the total of positions outstanding varies from around $15bn to $30bn+. These figures may seem small in relation to the global figure of $600bn a day quoted earlier, which is traded in the so-called “interbank*” market. But only a tiny proportion of the interbank business is ‘real’ risk business, generated by clients – as low as 5%, it has been suggested, i.e. maybe only $30bn. The rest is generated by banks trading among themselves in the act of “clearing” the exposures they have incurred. (Most banks have to end the day with their books substantially level; so most of their activity consists of laying off risks with each other in a cascade of transactions of diminishing size).

There is a broad preconception that the “forward*” interbank market is much more liquid, efficient and inexpensive than the IMM futures market. But that is by no means always so. If you deal in size (say $10m+ ) and have several banks and a Reuters screen, deal in forward currencies with a bank: if not, deal with a broker* in the IMM. The typical spread in the IMM is one point ($12.5) –meaning about 0.0125% (1 point in 8,000). Commissions vary from $12 to $120 or more. With care you should be able to deal well inside 0.1% or $1 per thousand. The IMM is a very efficient market.

Many of you, I know, would like more guidance on brokers. You know I can’t go around recommending brokers. But if you want help, look up “broker” in the glossary at the end of the book.