The Way of the Dollar

You’ll find more background on forward and futures markets in Chapter Nine, as well as some suggestions about what you should look for in a broker. Basically these markets allow you to take a bet on a currency rate at a future date, so you don’t need to pay for the currency you wish to buy: you just leave a margin of security for your bet. And you don’t have to bet your shirt: you just bet as much or as little as you like. Meanwhile, one more obstacle.

The “where is this currency headed” mind-trap

This mind-trap is a brute. With each issue of Currency Bulletin you receive, and from other publications no doubt, you expect answers. Every time a commercial wins an export order or places an import order, he feels he needs to make a currency forecast. With every business day that dawns,

active traders are asking questions and trying to predict the future. With every issue of CB I write, I am drawn into this trap and have to make a conscious effort to get out. For as we all know perfectly well, we can’t see into the future.

I’ve said the dollar can be forecast. So what are we to make of the fact that many of the most successful traders insist they do not attempt to “predict”, and regard those who do with scorn and derision?

The answer to the conundrum is quite simple –though it is elusive. If we feel we have to predict all the time we do indeed fall flat on our faces. Our results will not be a lot better than a pin. The way it works is that no matter what system we have, most of the time we cannot forecast. But at times we can forecast some parities, with a fair degree of reliability. This unsurprising conclusion is of the utmost importance.

Whatever system we have for analysing the currencies, the data we use will only be all present and correct occasionally. Most of the time we shall be unable to answer the question “where is this currency headed?”; and to attempt to do so is to fall into the trap. It’s only when the data are present and correct– when most if not all of the pieces fit –that we have a really good chance of beating a tossed coin. So it turns out that the technique of forecasting is mostly to do with being able to distinguish between those times when we have the right to forecast and those times when we don’t.

Let’s see how this happens in practice. In September 1990, the Yen had been tearing upwards. Currency Bulletin had forecast that it might do so in late August and early September – with some conviction: all the pieces were in place. By the issue of September 24, the Yen had moved from around

Y150 to Y137. But on little more than gut feeling, CB had earlier proposed a target of Y120 – which was nothing more or less than the previous dollar low. So one had to hang on. By the issue of Oct 8, the Yen was at Yl33. At this point CB could only fall back on conventional wisdoms – nothing wrong with that – like “let your profits run”. We shouldn’t blow it by “losing our position”. Note that the degree of certainty was much lower now. CB was in the area of guesswork. By the issue of October 22 the Yen had already touched its high for the year at 123.7– as near as damn it to the Y120 target. At this point CB actually admitted: “Now we don’t have much basis for forecasting any more.” In truth, it didn’t have any basis for forecasting. And so it was for much of the rest of that year.

So the answer to whether we can forecast the dollar is emphatically positive– so long as we admit that we can only do so occasionally, and fight the temptation to do so when we cannot. The point is that if you have a well– defined methodology for forecasting, you do have a good basis for knowing when you can forecast and when you cannot. Acknowledging the fact, when you can’t forecast, is not so easy.

But when it comes to actual trading, the ability to identify the action point is critical. In fact it’s what it’s all about. The only way you can win in the currency markets is to wait for the market to tell you when to act. And remember, the market knows nothing of our individual financial situations. The signal to act is not going to coincide with the moment we liquidate a bunch of securities, negotiate a new credit facility, win a big export order, or inherit money.

Currency Bulletin’s method of analysing the currencies is designed to identify the underlying trend and then to locate the extremes –the points at which corrections in the main trend begin and end, including the reversal of the main trend. We can’t predict those points, though we know what to look for in our four sentiment gauges (Chapter Five): we can only wait for them to identify themselves. When they do so, then we have to “go for it”.

CHAPTER TWO

“Nowhere is more nonsense talked than by currency experts about foreign exchange.“

SIR WINSTON CHURCHILL

In June 1984, at a conference on currency markets arranged by the Financial Times, the chief speakers’ topic was “Where did we all go wrong?” .In a similar conference the next year, the question was “Where did we go wrong again?” From 1982 to 1985, poll after poll showed 90% of the currency ‘experts’ bearish of the dollar, while the US currency climbed and climbed. How could so many experts be so wrong?

The glass that is half-empty is also half-full. The pessimist sees it one way and the optimist the other. So it is with financial markets. Most movements in financial markets are accounted for by swings in sentiment between optimism and pessimism. In the currency markets, almost all movements are accounted for by swings in sentiment, for reasons that will become clear. However observers want more dignified rationalisations for price movements, so a whole body of conventional wisdom comes into being, which may have no basis in reality.

This dead weight of conventional wisdoms encourages the idea that the currencies are complex and sophisticated. But once you strip away all the rationalisations and conventions that have no basis in reality, you discover the truth: which is that the currency markets are simple. And, so far from being highly sophisticated, they are, as I have suggested, remarkably naive. And there are good reasons for this, as explained. First, they have only been operating in their present free-floating mode since 1973 –for less than 20 years. Second, surprising as it may seem for such momentous markets, there are precious few full-time forex specialists aside from dealers.

The floating* of the dollar

It’s understandable that most of the ‘pros’ went wrong in 1982-5. They were conditioned by history. Aren’t we all? Before 1971, the major currencies were fixed in relation to the dollar, which was in turn fixed in relation to gold (one ounce of gold to $35). This is fine until some country’s

inflation rate gets out of line. Then its domestic price levels would run up above its neighbours; its exports would get too pricey and imports would become excessively cheap. The currency , in a word, would become uncompetitive; and the result was usually a balance of payments crisis, as the trade account ran deep into deficit and foreigners lost confidence in the currency and sold it to repatriate funds.Britain suffered such a fate in 1967, and the only solution was to devalue, as sterling did in that year (not for the first time). In fact this was a regular occurrence among the so-called “weak” currencies like the Italian lira (Lit) and the French franc (FF). By contrast certain “ strong” currencies like the D-Mark (DM) and Swiss franc (SF) occasionally ran up such big trade surpluses and encountered such big speculative inflows that they had to be revalued upwards.

Britain, Italy, France and other European countries like Spain were all inflation-prone countries. But of course their inflation rates were tame stuff compared with those of many Latin American countries –the “banana republics” with monthly inflation rates in double figures. If domestic price levels double every 6 months or so, the