The Way of the Dollar

billion or more to clear a $700m deal.

The effect of the VW order is likely to be that the buck rises somewhat against the DM. At some stage, the rumour of “commercial demand” may hit the market. But in any case, during the clearing process, there will be room for all sorts of other rationalisations as one dealer after another is hit for dollars against DM. The rationalisations will depend on what is upper– most in the dealer’s mind; on whether he’s a chartist, on what was in the papers (if he reads them); on what the market is saying; on what the Reuters screen is showing. And all this goes on against the background of hundreds of smaller deals by lesser companies and individuals –treasurers, investors and speculators.

All participants can be divided into two classes –those who buy on a rising price trend/ sell a falling one (1 call them price-led* traders), and those who buy a falling trend/ sell a rising one (value-led* traders). The former are trying to buy high and sell higher; the latter are trying to buy low, sell high. They are two different mentalities. And most of us tend to act one way or the other – though occasionally we change places. We don’t always behave the same way. However, the point about the currency markets is that the great majority of players tend to trade in the same direction as the trend. They are trend-followers not trend-buckers.

How come? Will it last? While it does, can it help us to trade, knowing this is the way it is?

Let’s recap. In the old days, in the 1970s, currency participants followed certain rules which worked pretty well. The rules were to do with various measures of whether a currency was overvalued or cheap – notably Purchasing Power Parity and competitiveness in international trade. In the 1980s, the rules stopped working –as we’ve seen. Something else drove the currencies, namely a combination of inflation and interest rates, roughly summed up in real interest rates. Unfortunately, we can’t forecast interest rates –let alone real interest rates. So in the 1980s, the punters went wildly

astray. But as they looked back on the history of the great dollar bull market of 1981-5, and the subsequent great bear market of 1985 to 1987, observers saw that the main dollar parities had been moving in huge sweeping trends. The heroes of this period from 1981 to 1987 were the trend-following chartists.

Take a look at any chart of the dollar and you cannot help seeing the great sweeps up (in 1981-5) and down (in 1985-1987). Trend-following worked. And it was the only thing that worked –or so it seemed to many.

In fact there were good down-to-earth fundamental* reasons for those great sweeps in the dollar. Fed chairman Paul Volcker’s single-minded attack on US inflation in the 1980s was a once-and-for-all affair. It was momentously effective, and with it went the highest real US interest rates in living memory. The effect on the dollar is history. Having marched up to the top of the hill, it had to march down again. But the experts in “fundamentals” had by and large proved incapable of explaining the antics of the dollar – let alone predicting them. When they had at last concluded late in 1984 that the dollar moved in response to portfolio flows and nothing else, this knowledge in no way helped them to plot the course of the dollar’s subsequent peak and its collapse from March 1985 through 1987. Blind trend-following worked better. In fact it worked impeccably, with hindsight.

But the rise and fall in the dollar from 1981 through 1987 was an exceptional affair, due, as explained, to non-recurring circumstances. From 1987 into 1990, the dollar bottomed and rallied or trended sideways according to taste and which currency you choose. In this later period, the trend– following approach was less productive. But even though it

was no panacea for profits, it seemed to work well in the circumstances, with hindsight. The Swiss Franc provided some useful trends. So, in their way, did the Canadian and Australian dollar in 1988– especially against the non-dollar currencies – and so, above all, did the Yen after late 1988.

In other words, a trend-following approach still seemed valid to observers, so long as it was refined to fit the new circumstances. If the dollar was no longer moving in immaculate, narrow multi-year trend-channels, you had to cut down your time horizon so that it was measured in months –or even weeks. And if the performance of the non-dollar currencies was no longer homogeneous –if the pack had broken up –then new opportunities might be sought among the non-dollar cross-rates*.

Since about the Spring of 1988, the divergences among the major currencies have been at least as striking as their movements against the dollar. In fact in the case of the Yen, the movement against the European currencies was much more pronounced than against the dollar. Why? What’s going on?

In a word, trend-following. In the first place, the dollar in the late 1980s was perceived to have reached a sort of equilibrium level, where observers by and large did not feel it to be notably overvalued or undervalued. The US trade gap was more or less stable; and real US interest rates seemed to be roughly in line with those elsewhere. Anyway, few observers any longer

had any confidence in their ability to predict the course of the dollar on the basis of the “fundamentals”*; and without the benefit of hindsight, its trending had become unreliable. So they were happy to throw in the towel and try a different game. The new game was spotting trends in the cross rates. For instance, when

the rise in sterling against the D-Mark got overdone and it began to fall back from its peak of DM 3.27, Lo! you had a trend: for sterling had been falling against the DM ever since the War, after all. And when the DM moved up out of its decade-long trading range of 8O-85c against the Swiss franc, you had another trend, as it moved first to 90c and then to 92c. The same thing happened when the Yen began giving up some of its long-run gains against the D-Mark, and the DM rose with little respite from near 70 Yen to 95 Yen.

These trend movements, with the possible exception of the Yen, have been defined with hindsight. In real time, what you see is a price movement, giving way to a fluctuation, which in turn gives way to either a continuation in the price movement (a trend?), or a reversal to the opposite direction (a new trend). Brokers and bank dealing desks of course love clients to deal in the crosses*: they generate more income in commissions and spreads. But is there any way of forecasting them?

We have two bare decades of continuous experience of floating currencies. Until recently, practically all currency trading was conducted through the dollar. That meant that if you wanted to buy D-Marks for pounds –or for SF or whatever –the rate was calculated via the dollar (and so were buying– and-selling spreads). Recently this has been changing, as more banks have begun to deal the major cross-rates direct, without reference to the buck. The trend got further impetus when the IMM decided to trade the D-Mark crosses (Ј in DM and DM in Yen & SF) starting 29 May 1991. The change has probably contributed to recent volatility in the cross rates. This volatility could be here to stay, so there may be a greater need to forecast the crosses. Is it possible?

The answer is, I suspect, that good price-based traders have had, and may still have, a window of opportunity with the cross-rates, because they’re relatively untrodden ground – though maybe not for long. For others, the opportunities for forecasting significant cross-rate moves are scarce.

The dollar parities offer more reliable pickings, I think. Over the years, we have been able to monitor the relationships between the dollar and such things as interest rates, inflation, trade, politics, money supply, economic growth and the other fundamental data. We have also been able to watch the interaction between currency values and other data which are more concerned with the psychology of the participants –the indicators of sentiment.

Watching these relationships over the years, one has seen the false prophets among them hog the limelight; observed the quiet workings of

the valid relationships; noted currency experts being hoodwinked; seen the well-meaning, plodding efforts of the media (I was once a newspaper columnist, so I can empathise). Over time I have come to believe that probabilities can be found in the dollar parities which cannot be found in stock markets or bond markets. I think the currency markets are in fact easier to forecast.

So which are the valid relationships, the ones that have worked reliably over time? And which are the frauds? As with all such questions, you need to throw out the preconceptions and start with a fresh slate. “Go back to before ABC”, as Levi Strauss or someone said.

At any moment, the price of a currency represents equilibrium between buying and selling pressure. What