The Way of the Dollar

causes a price to change is a change in pressure. Change is the first factor to isolate. But of course pressure can change daily – even hourly or every minute –and weekly and monthly and yearly. We’re lost unless we know what time frame we’re dealing with. To get a line on that we can look at a few price histories and remind ourselves that there have certainly been price swings that have been measured in years, punctuated by counter-moves measured in months. In other words, we must be on the look-out for relationships that are valid over multi-year spans and others which are valid for multi-month spans –and maybe others valid for weeks or just days.

In real life, these divisions are very elusive if not illusory –existing as they do only with hindsight. In real life, we live in a continuous present where days turn into weeks, and weeks turn into months and so on. The trick which helps us cope with this situation is to ask “what is the underlying trend?”. If you can diagnose such a thing and find a valid underlying rationale for it, then you can divide daily and weekly and monthly fluctuations into l) those that are in line with the trend and 2) those that are counter-trend moves. This simple ‘with-or-against’ distinction helps keep you on your time-frame track.

Fundamental driving forces

So what constitutes a “valid underlying rationale” for a price move? In two words, expected return: or more specifically expected total return* over the foreseeable time-horizon. If you go right back to before ABC, there can be no other driving force behind a price move than a change in expectations of total return. So the factors that enter into total return will be the forces that drive supply and demand for currencies via changing expectations. The quantifiable ones are interest yields* and inflation: just those two, simple as that. The unquantifiable one, the future exchange rate,

sellers, what else is new? Well, there’s nothing new under the sun, as the prophet said. But here goes. Following from the plodding analysis above, there are a couple of positive conclusions; quite a lot of grey neutral territory; and a whole lot of cumbersome baggage we can assign to the trash can. Let’s start with the baggage.

What about trade and money supply and budget deficits and employment and economic growth? And what about intervention and political events like German monetary union? And what about capital flows? Well where possible, I have tracked these factors and found out, empirically, whether they do have any reliable relationships with currencies. Some are charted in this chapter and others elsewhere in the book, and you can see with your own eyes that most of the supposed relationships are myths. And remember that a supposed relationship which

reliable is absolutely useless – except that it can sometimes be used as a contrarian indicator: if you know the crowd is following a false trail, it can give you the confidence to go against the crowd at the right moment. The point about the above factors is that they have no direct bearing on actual total returns, yet they are reflected or discounted* in currency rates. They produce deviations from the norm – excesses or counter-trend moves – which must be ignored or countered, if we are not to be blown off course. They are in fact just noise.

One can state categorically that there has since 1980 been no reliable relationship between the dollar and:-The US trade balance; economic growth; money supply; budget deficit; capital flows; and oil prices.

This has been true both for the absolute US figures and for the US data relative to other countries, which can be measured as differentials. The purported relationships here come into the “absolutely useless” category.

Admit it: that simplifies matters a lot. Note that many of these data are thought to have a bearing on the outlook for interest yields, which is why they are avidly watched by currency observers – for the existence of links between currencies and interest yields is not in dispute. We shall return to that. But what of intervention and political events?

Political events, like the timing of sterling’s full adherence to the EMS, German reunification, Russian Revolution of ’91 et al can undoubtedly have a more than temporary impact on dollar rates and cross rates alike. Who can forget the effect of James Baker’s efforts to jawbone the dollar down in 1986– 7? So yes, there may be things to keep an eye out for there,

but not nearly as many as observers think. Baker’s efforts, for example, were highly successful. But was that just because they were in the direction of the perceived trend in the dollar anyway? And the difficulty with most political influences is the sheer impossibility of knowing to what extent they have been discounted in the market-place.

Much the same has to be said of intervention. We have seen it blown away so many times. And the times we have seen it succeed have usually been the times when there was other evidence that the tide was turning –or when it was in the direction of the trend as in 1985, when the central banks were “pushing down on a lead balloon”. So one has been forced to the conclusion that intervention –or at least the prospect of intervention is another piece of baggage that must go; we can heed it only when we can look back on a pattern of intervention which corroborates a script drawn from other evidence. And then we had jolly well better heed it.

Note here a proviso to the conclusion that US trade is part of the excess baggage: it doesn’t mean that relative trade performance among non-US partners should be ignored. Nobody much looks at that. Yet see what a good account the differential between German and Japanese trade gives of the Yen/D-Mark cross rate – a relationship that has been valid ever since currencies floated free. How so? Because no-one is looking there.

But the heaviest piece of baggage has to be interest rate forecasts. That’s where everyone is looking. Remember the mullah and his key. Forecasting interest rates is not where it’s at. I think the attitude of all the punters out there is that this is the holy grail: if only we could forecast interest yields we would know where the dollar was headed. If only we could, maybe

we could. But we can’t, and even if we could, maybe we still couldn’t! Currency forecasting, like all forecasting of financial markets is the art ofthe possible. It’s impossible to find the key out in the bright sunlight when it's hidden in the dark – in the depths of people’s hearts. Meanwhile, here are some conclusions about the valid underlying trend.

1) An emerging perception that a currency has stabilised or entered an uptrend combined with a relatively high real interest yield strongly favours an upward movement; and an emerging perception that a currency has stabilised or entered a downtrend combined with a relatively low interest yield strongly favours a slide.

2) On empirical evidence you can count on a significant time-lag before a big shift in real interest rates makes an impact on a currency: no hurry, and no need to forecast.

3) What matters with interest rates is not where they have been moving but why. There is no reliable direct link between interest rate movements and currency movements. Most of the time, you will see an inverse relationship. The reason for this is that most of the time, currencies are leading interest rates rather than the other way round. So when do interest rates lead currencies ? And when is this relationship reliable and useful? Answers next chapter.