The Way of the Dollar

in the world to one of the lowest –which shows up in the “real bond yield differential” in the chart above.

Then, in mid-1984, US interest rates began to fall, and with them dollar bond yields. Did this at last undermine the dollar? Not at all. The cup of investors holding dollars in the form of dollar bonds ran full to overflowing. The dollar was rising and US bond prices were rising. The combination of the two made fortunes for dollar bond holders. To sum up, the lessons of the early 1980s were as follows: The currencies were dominated by common-sense investors, who recog-nised the intrinsic value of the US dollar as the world’s money. In the early part of the decade the US currency offered very high yields and “good value”: money piled into the dollar. Later on, the world’s currency was seen to be “rising” and still offering the highest yields available on any major currency , and one of the lowest inflation rates: more money piled into the dollar. Finally, when dollar yields began to fall, these common-sense investors found themselves holding bonds that were going up in value denominated in a currency which was rising in value: money cascaded into the dollar. High yield; rising bond price; rising currency: what more could you want. This was investor Nirvana.

The observers who were concerned with America’s deteriorating trade account and the dollar’s increasing “overvaluation” were out of synch with the tune that was being called by the common-sense investor. What did he care about trade or PPP? His monthly asset statement told him he was right and the professionals were full of hot air.

There is an old Sufi tale about a mullah (Nasruddin) who was discovered by a passer-by searching in the dust outside his house. What was he looking for, the stranger enquired. A key, said the mullah. Where did he drop it? “In the house” replied the mullah. Then why was he looking in the dust outside? Because here he was in bright sunlight, whereas in the house it was dark and difficult to see.

It happens to us all the time. The solution to worthwhile problems is never out there in the open. The key to financial markets is elusive. It must be so – by definition. The price-discounting mechanism ensures that the majority are always looking out there in broad daylight, when the key is somewhere else, in the shadow. –

And when the key is discovered by the crowd – in this case that it was collapsing inflation and high real interest rates that powered the dollar up –why, then it’s too late.

CHAPTER THREE

How currency observers lost the plot.

To avoid this impasse we have to distinguish

what is useful for forecasting from what is useless.

During August 1990, in the aftermath of Iraq’s invasion and an nexation of Kuwait, the dollar fell like a stone; gold rose; bond yields rose; and stock markets cracked across the globe in the sharpest break since the Crash of ’87. Part of the background, you recall, was an embargo imposed by the United Nations on oil exports from Iraq and Kuwait, which cut away one fifth of OPEC’s production. Not surprisingly the price of oil soared, with obvious implications for inflation: and the rise in global bond yields was attributed to this cause. But for the rest, the market reactions were by no means a foregone conclusion. In fact, they were quite perverse as a whole.

If you had had foreknowledge of the unfolding situation in Arabia, you would have been justified in forecasting that the dollar would rise, along with most stock markets. The dollar, after all, has always been a haven currency in times of international upheavals; and wars have traditionally been good for stock markets; for good measure, too, America reported in mid-August an exceptionally good trade figure, with a deficit $2bn lower than expected. Knowing too that gold was in a bear market, and recalling how the gold price had slumped after an initial blip following the Crash of ’87, you might have guessed that something similar would happen this time. Well, as we know, you would have been very wrong on all counts.

You might conclude that speculating about events in the outside world and basing forecasts on these speculations is hazardous. You might, but it wouldn’t help you much. You might also conclude that speculating about events in the outside world and basing forecasts on these speculations is a hiding to nothing and something you should not do. That conclusion could be very helpful. That sort of speculation is what everyone is engaged in, and it does them little good. If you don’t do it, you could

be doing yourself a great favour.

In the event of a global disturbance, the dollar, it seems, can go up; and it can also go down. Obviously what we need to look at is the background of circumstances in which it is likely to go up and those in which it is more likely to go down. We can call these the set-up conditions*.

You will read in the papers – or hear from “the market-place” –that the dollar rose for “x” reason. For example:-because of a tightening in US money supply / an acceleration in the US economy –implying higher US interest rates ahead;

–because of an increase in oil prices, since oil is paid for in dollars; –because of a dip in US inflation;

–because of a blip-up in US inflation implying interest rates would need to be tightened;

–because of a better trade figure;

–because of a worse trade figure, implying US interest rates would need to be tightened;

–because of Fed intervention to support the dollar;

–because of Bundesbank intervention to support the D-Mark (punters decide to ‘take on’ the German central bank and sell the OM);

–because Currency Bulletin recommended the sale of OM!

–because the US Treasury indicated it would be happy with a higher dollar;

–because the Bundesbank said it wanted a higher D-Mark!

–because the dollar had broken through an important chart resistance level.

–because the DM had completed a reverse “head and shoulders” you name it.

That’s the financial press. The rationalisations are… well, inconsistent. By far the best reportage of market rationalisations is to be found daily in the Wall Street Journal. And the Journal is not giving its own views, but reporting those of the best-known names in the currency business –the pundits from Bankers Trust, Harris Bank, Goldman Sachs, Credit Lyonnais, Salomon Bros, Credit Suisse, BNP, Midland Montagu, Barclays Bank, Nomura and the rest.

There is an old stock exchange saying: “the market is always right”. What the pundits are quoting (many are on the dealing side, executing orders for clients), are the actual rationalisations of the participants. And these are often inconsistent. But WE, you and I, cannot base our forecasts and actions on inconsistent rationales. We would soon be wiped out if we did. We are not playing with other people’s money.

So what’s going on? In the first place, the markets, remember, turn over more than $600bn a day. The great bulk of this trading is very short term. It works something like this. Volkswagen wants to buy $700m in exchange for D-Marks. (It needs the dollars to pay bills, let’s say). It approaches a series of banks and does $5Om here and $100rn there until it has filled its needs. These banks then proceed to buy back the dollars sold to VW , and sell their excess D-Marks. This is the so-called “clearing process”* whereby supply and demand are meticulously balanced against price. Note that, at the end of the day, most banks have to have their books more or less in balance, or ‘flat’*. And during this clearing process the banks may turn over $l0