The Way Of The Dollar Part 1

The Way of the Dollar.

John Percival.

PREFACE.

To the Web Edition a" year 2000

Itas about ten years since I started writing The Way of the Dollar . Reissuing it for the web has been a curiously time-consuming endeavour a" for mainly technical reasons a" even though I decided to reproduce it in its original form rather than in a revised edition. But of course times have changed.

Currency Bulletinas methodology was settled in the mid-1980s and has remained fundamentally unchanged ever since. Up front, it has to be said that the currency markets have become highly aefficienta, by which we mean that the supposed price-sensitive information is effectively discounted in prices so that attempts to antic.i.p.ate price movements in the major dollar parities on the basis of such information have, over time , tended to be no more successful than a pin. This concept sounds easy to grasp, but in practice people have great difficulty with it: even if they see it must apply in general, there often seem to be good reasons why it doesnat apply in a particular case (where we think we have a special angle on the data; where we think it may not yet be discounted). CB simply accepts that it is a waste of time. The approach adopted by CB and set out in TwotD was to look elsewhere to an area of inefficiency in currency pricing which seemed to be consistently reliable.

The a.n.a.lysts out there are looking for the explanation for currency movement in future events a" such as interest rate changes; or central bank actions; or s.h.i.+fts in economic growth. The degree to which any event is discounted in price and the scope for insight or inside knowledge in such areas is small, and not too susceptible to systematic study. In this, currencies differ from stocks, for example, where expertise can be acquired in the way of specialised knowledge of individual company affairs: ditto with certain commodities, I imagine.

The alternative is to concentrate on determining what it is that the crowd is expecting, which is what is already discounted in prices, and on evaluating the degree of the crowdas commitment. CBas theory is that this is where the most reliable inefficiencies in the currency markets are generated, when the crowd gets over-committed to a view of the future. And the degree of over-commitment can be gauged in various indicators of sentiment among currency observers and partic.i.p.ants a" the level of speculation and consensus, in particular.

Three basic a.s.sumptions were that 1) the crowd tended to lose money; 2) that it tended to be aright for the trends but wrong at both endsa; and 3) that therefore it would pay to go contrary to the crowd at the aendsa or price extremes. None of the above was too contentious, but the a.s.sumptions take you nowhere unless you have a way of locating the price extremes. The formula CB settled on was to define the extremes, not in terms of price but in terms of sentiment . The underlying equation was: a price extreme = an extreme of consensus + an extreme of speculation.

Naturally you can, at any moment, point to some other driving force like a divergence or convergence in growth rates; or a rising or falling stock market; or a s.h.i.+ft in central bank policy, via intervention or interest rates. Recently, observers have put the finger on equity and direct investment flows. Any of these can be or seem to be the determinants of currency movements. CBas contention was that this might be so, but that you were more likely to lose money following such episodic rationales than following a consistent contrarian, sentiment-based approach, which was founded on human nature. And it worked.

In two decades, there were a few periods when the ebb and flow of sentiment was distorted or overwhelmed by unpredictable forces. In the mid-1990s, the automated trading systems were disrupted by a series of astop-loss-cascadea moves that looked to have been triggered by other market partic.i.p.ants. These movements were sufficiently violent to upset most methodical traders (including CB) but they nicely ill.u.s.trated the critical weight of aset-up conditionsa a" speculative positioning particularly a" as an engine of price movement. The moment pa.s.sed. Then in the second half of the 90s came the thundering horde of macro hedge funds, throwing many tens of billions at the Yen carry trade (and dollar/DM). The disruption here was that the flows self-fed to an unprecedented degree as the size of the forex-active hedge money mushroomed a" meaning that the extremes that CB gauges got that much more extreme. That moment pa.s.sed too. Hedge money has retired hurt from the currency markets, leaving them much slimmer.

The point about sentiment is that itas always there, always at work, and always offering an edge to exponents who have been able to keep their finger on the pulse of sentiment (and this applies to all financial markets, and always has). The rationales that partic.i.p.ants use to justify their expectations and positions are simply the raw material underlying the ebbs 4 and flows in sentiment. We cannot use them, but keeping up with them is part of the business of keeping oneas finger on the pulse. In this respect, nothing has changed since TwotD was first published in 1991.

Has the existence of the book, and the fortnightly appearance of Currency Bulletin for nearly 20 years a" has this exposure of a successful methodology to the public gaze changed the odds and blunted our edge when it comes to trading? Certainly, there is much more awareness of the relevance of positioning and consensus in currency fluctuations, regardless of CBas contribution to the matter. I just donat know whether we have lost some of our initial edge. I see the approach working a treat all round. In the broad sweep of the dollar and the euro and in their minor mood changes; in the twists and turns in the commonwealth dollars; in the fluctuations in euro/SF; in the fas.h.i.+on s.h.i.+fts in sterling.

Which leaves the adaptations we need to make for more widespread awareness of sentiment out there. Most investment banks now make some attempt at tracking clientsa positions. At least two banks, Deutsche Bank and the Dutch bank ABN-Amro publicise their research in the area in the sense of allowing the media some access to it. As far as I know, Deutsche Bank does the most comprehensive work in this area a" and very good it is too. When it comes to coverage of forex exposures, the danger is that the more comprehensive you aim to be, the greater the danger of producing a soup with no information. For every buyer there has to be a seller after all. CBas aim has always been to concentrate on the speculative segment. To this day this is most purely represented in the IMM open interest.

Deutsche Bank has added a valuable nugget however. CB prides itself on being able to read and interpret the bare IMM OI figures in the context of price movement: they have the huge advantage of being available daily (at about 1.00 pm London-time) for the previous day. We have never been able to make good use of the weekly figures produced by the CFTC for the commitments of traders a" at least until DB came along and charted the series. That showed that the figures seemed to successfully separate out the speculators from the specialists and pros, thus giving a good picture of net speculative exposures. As noted this is only on a weekly basis and 5 days late, but it gives an interesting check on our subjective interpretation. Just for instance, the weekly series showed net speculation significantly long of euro during its July-August decline, which is something we could not necessarily have gleaned from the raw daily OI figs.

Amazingly, for the rest weare back where we stood in 1991. The consensus gauges were never something we placed much reliance in: they needed to be confirmed by anecdotal evidence from market gossip. The aperception of the trenda (TwotD page 50) has been refined into a price target gauge, in the light of the recurrent phenomenon, as the consensus hardens, on the direction of the trend a" that price targets get extended further out: an intuitive indicator, this. The areaction to newsa gauge is as valid as ever a" no more no less a" being used as confirmatory indicator of a trend that is in the process of changing.

What about the introduction of the single currency to replace the nine currencies of EMU ? important as it is, it hasnat changed any part of CBas methodology, which has always been based first and foremost on the main dollar parities. As far as they are concerned the euro has replaced the D-Mark, and thatas that. The weight of the euro, however, has created a new major parity in the shape of euro/Yen a" and some minor parities of more significance than their DM cross rates had, like euro/sterling and euro/ SF. The result has been to complicate the a.n.a.lysis of cable and dollar/SF as well as dollar/Yen, and we had better recognise the fact, by staying out when in doubt.

Which brings us to a key conclusion about currency trading today as compared with 1991. The pulse of sentiment is not always as clear and strong as it was in those old days: therefore we need to stay out more often and trade less often, by cherry-picking more carefully; and/or widen the area of operation by bringing in other currencies that we rarely traded in the old days a" the ones that fit the bill being the CAD and AUD, since we do have IMM data for these series. But most important now is to cultivate the James Rogers mindset. Remember? aI donat play. I just donat play. . . It happens all the time. I donat do anything until all the pieces fita (see page 86).

As I reread TWotD it seems to me that very little of it needs to be changed. Still, some things just donat apply any more, like the section on alooniea behaviour (page 73). It really did work once upon a time, but now, forget it. Trading via the internet may seem a tempting option, but there are various prerequisites which are seldom all met. The counterparty must be personally known to you; should have least an AA credit rating; and an office that you have actually visited; and buy/sell spreads should never exceed 3 points. As far as I know, all these conditions are not often fulfilled. In most cases, itas a context that suits the counterparty a" because costs are low and personal contact minimised a" but not necessarily the client. What the internet has done is to give everyone access to free or cheap price and news services. Beginners can get a running start by consulting the site of our a.s.sociate, dynexcorp.com, with its valuable links.

Introduction to the printed edition of 1991

The currencies are emerging during the 1990s as a anew a.s.set cla.s.sa, for investment in their own right, alongside stocks and bonds.

The breakdown of the Bretton Woods* system and the floating of the major currencies in 1971-3 transformed the foreign exchange markets. Instead of being concerned mainly with trade they came to be dominated by portfolio flows.

The effect was that a new global financial market was born, which rapidly grew to dwarf all the other financial markets. As usual, the perception of the transformation lagged behind the event. Partic.i.p.ants only began to cotton on in the mid-1980s. And they still havenat done much to change their thinking about this huge market.

What makes prices move? In the securities markets the answers to that question have been more or less known for decades. In the currency markets, very few partic.i.p.ants have any idea, still.

Starting in 1981, Currency Bulletin spent the next decade a.n.a.lysing, proposing, eliminating. Quite early on it became apparent that the main driving forces for the price of the dollar, which is the unit in which the prices of most currencies are measured, were the same as in the securities markets.

The fundamental driving force was the urge to maximise total return a" in yield and price movement. What else could it be? Superimposed on this aunderlying rationalea was the ebb and flow in sentiment among the partic.i.p.ants. At times, sentiment could become the sole determinant of price movement.

The a.n.a.lysable element in total return in currencies is the yield, of course: the price is what we wish to forecast. So the first thing to do was to see whether there are any rules governing the relations.h.i.+p between yield and pricea" like the relations.h.i.+p between share prices and corporate dividends and earnings. The result is positive. There do seem to have been certain relations.h.i.+ps that are more or less useful for prediction a"perhapsmore useful than the link between corporate earnings and share prices.

The next thing was to see what measures were available of bullish and bearish sentiment in the currencies and whether any could be used to antic.i.p.ate changes in price trends. Again, the result is positive a" though if you want objective measures, they only exist for the main dollar parities, not for cross-rates like sterling in D-Marks.

Finally one had to see if there were other relations.h.i.+ps which had any predictive value for currencies a" like inflation, trade, money supply, oil prices, economic growth, et al. So far, the conclusion is that few such relations.h.i.+ps a" and none of the relations.h.i.+ps that most observers seem to rely on a" are useful for predicting the dollar. The few exceptions are of course commensurately valuable. The advantage is that this greatly simplifies the task of a.n.a.lysis.

So much for the basic groundwork. It allowed Currency Bulletin to evolve a systematic approach to forecasting the dollar which has worked well for several years. Because the systemas const.i.tuent parts are mostly based on human behaviour which doesnat change, not on fas.h.i.+on, we can be confident it will continue to work.

The financial markets, as anyone familiar with them knows, are deeply paradoxical. They have a logic of their own which is in a way the opposite of normal logic; Hence the market adage asell on the newsa applies to good news not to bad news. Hence other bits of market lore like aa bull market climbs a wall of worry: a bear market flows down a river of hopea .Markets do whatever they need to do to confound the greatest number of people.

This happens because prices reflect expectations. If everyone expects unemployment to rise, or a trade balance to fall, or inflation to remain steady, there is no intrinsic reason why they should be wrong: the expectation doesnat affect the outcome. But if everyone expects share prices to fall, or the dollar to rise, there is every reason why they should be wrong: because current share price levels already reflect the expectation of lower prices, and the current level of the dollar already discounts a rise. In other words, the expectation vitiates the outcome.

Understanding this discounting mechanism of markets is a great help in forecasting them. Unfortunately it is no panacea for trading them profitably. In aefficienta and sophisticated markets, like the major stock and bond markets, enough people know about the discounting mechanism so that the market still manages to do what it needs to do to confound most traders.

This book is about both forecasting the currencies and trading them profitably. For relative newcomers, there is an alphabetic glossary of terms and concepts: normally there will be an asterisk * in the main text marking terms to be found in the glossary , on the first couple of occasions they appear. Some readers may find it helpful to read through the Glossary before starting on Chapter One.

The book is intended to help you better understand Currency Bulletin as you follow it over the months and years. My chief message is this. When we understand the real driving forces behind currency movement, we will find again and again that they differ from those with which the consensus is preoccupied. This is not something we see so often or so clearly in the securities markets. It enables us trade against the consensus with consistent success. It makes not the slightest difference which way the currencies are trending: an uptrend in one means a downtrend in the other. So it's realistic to aim for systematic profits irrespective of trends, year after year. These profits won't come by themselves: we will win them by achieving the right state of mind a" which is what Part II of this book is about.

Since trading the currencies ties up little of our capital (being done in the forward* or futures* markets), such systematic profits can be earned alongside of whatever returns we can achieve in the securities markets. Moreover the returns we achieve trading currencies are completely uncorrelated with returns in the securities markets. This diversification implies it is possible to run the two activities side by side to achieve higher returns at lower risk than can be achieved by either alone. Then we leave the miracle of compounding to do its own work. There are some astonis.h.i.+ng examples of that work in Chapter Eight.

CHAPTER ONE.

Those who know do not talk. Those who talk do not know."

LAO a"TZU And those who can, do; those who can't, write? Well writing is some thing I do; and trading is also something I do. And I'm still learning how much I don't know about both. Here's another confession. I see the currencies as the biggest, most fascinating, most profitable and most dangerous casino in existence. No, it's not really a casino. In casinos you cannot win by skill. In currency markets you can. But it is a casino, in practice, for most of the people involved: only they don't put on their own bets. For most partic.i.p.ants, the currency gamble they find themselves involved in is an occupational hazard. The European investor who buys j.a.panese stocks or US bonds; the contractor who bids for a contract in the Middle East; the multinational corporation which borrows in dollars; exporters, importers, s.h.i.+ppers, travel agents, economists, Chancellors of the Exchequer, bankers, oil companies, fund managers a" all of the above find themselves involved with an international exchange which reportedly tots up a volume of over $600,000,000,000 a day. It isn't their business; they can't a.s.sess the risks and rewards, and yet the risk from currency movements may be the biggest risk they run.

The question is: can currency movements be forecast ? As it happens, here in the 1990s, the currency markets can, I think, be forecast more reliably than any other major financial market. This is odd, if only because of the sheer size of the market. A big free market like that ought to be what academics call "efficient". By this they mean that it works so well, that everything that can be foreseen is efficiently discounted in current prices: so no-one can forecast future prices except by luck. But what I am saying is that you can forecast the dollar, systematically, if you follow certain simple rules.

These rules follow from the character of the partic.i.p.ants in currency markets. The way the great majority of them think and act dictates the rules. So it does in the other financial markets a" stocks, bonds and money markets. But there is a crucial difference between the currency markets and other financial markets. The difference comes about partly because the currency markets, in their present afloatinga form, are so young, dating back only to 1971. The difference is that compared with other major financial markets, the partic.i.p.ants in currency markets are naive.

What do we mean by anaivea? The securities markets in the major financial centres have an immense wealth of wisdom behind them. Literally thousands of books have been written about the securities markets. Billions of man hours have been used up by seekers after the secret of what makes securities prices move and how to abeat the marketa. This is hardly surprising since the securities markets are a major part of the store of wealth of developed nations, and itas all quoted, so anyone who had a way of predicting price fluctuations could make a fortune. You canat quite do this in real estate, which is the other major store of wealth. But you can invest your savings in shares or bondsor real property .You can acc.u.mulate wealth through capital growth and income, and the acc.u.mulation can, at least in theory, be greatly compounded by timely s.h.i.+fts between shares or property and bonds. And this is the way most investors think and act.

For every thousand stock traders there is maybe only one currency trader Traditionally, people have never looked at currencies as a major area for investment. Why should they? In the old days, the major currencies tended to be fixed in relation to gold. Even today, after two decades in which currency rates have been fluctuating freely in the same way as securities prices, most people a"businessmen and investors alike tend to see currency fluctuations as something external and outside their control. In the securities markets there are millions of people involved whose sole aim is to make money out of price movements. In the currency markets, you have an army of dealers and brokers, whose business is to execute transactions and close their books at the end of the day; you have another army of commercials, including corporate treasurers, whose business is to protect revenues/ a.s.sets from financial risk; a host of fund managers, security a.n.a.lysts, and economists whose business is stocks and bonds; a relatively small band of speculatorsa" few of whom have currencies as their main interest; and a"wait for it a"aabout a dozen foreign exchange managers [whole handle straight foreign exchange accounts using specialised approaches. a The quotation is from a brochure advertising a seminar in New York in July 1991, ent.i.tled aForeign Currency a"The New a.s.set Cla.s.sa.

So, one way and another, the resources and time that have been devoted to the study of securities over the years have never been allocated to currencies. Thatas why the acc.u.mulated wisdom isnat to be found in currencies. This, of course, is terrific news. Obviously, the fluctuations in currencies offer inexhaustible opportunity for the acc.u.mulation of wealth: the good news for you and me is that there is so little compet.i.tion. Naturally the currency markets offer equal opportunity for losing wealth. But not if we follow the rules which put the odds firmly in our favour. The rules are what this short book is about; the rules about forecasting and about the actual practice of trading currencies.

Not that the currency markets have to be seen as an exclusive alternative to the securities markets. Not so. In the first place, trading currencies doesnat need to tie up a lot of capital, so you can do it side by side with portfolio investmenta" or indeed side by side with investment in real a.s.sets. Secondly, many of you readers are not too concerned with the investment angle of currencies at all. Your interest is in the business angle. Currency fluctuations, after all, represent one of the biggest commercial risks in your business if it is at all international. Theyare an occupational hazard.

The challenge is not to eliminate risk, but to profit from currency fluctuations In this respect, acommercials*a are in the same boat as investors. We cannot avoid the issue of currency fluctuations, whether we are international businesses or global investors. How does one respond to such a situation? Why, by making a virtue out of necessity. If we canat avoid currency fluctuations, letas try and turn them into a profit-centre. This goes as much for commercials as for investors. In fact I think the position of both vis-a-vis currency fluctuations is the same. If you cannot or do not wish to incur currency risks, you can take steps to protect yourself from them, by taking out insurance and hedging* intolerable risks.

But if currency movements can be forecast, then what the game is about is not risk-elimination but risk-evaluated maximisation of performance. And this applies to all of us, commercials and investors alike. So this book is directed to readers who are ready to take up the challenge to try and make money out of the currency movements a"or at least save money .And my pleasant job is to show you beyond reasonable doubt that it can be done and suggest how to do it.

But a word of warning to investors. About 99% of the human race is unshakeably convinced that the value of real estate property must rise over time as surely as the sun will rise tomorrow; and that any pause in this remorseless trend will be momentary. You find the same universal conviction among followers of equities. Itas taken for granted that bear markets and crashes are just buying opportunities which pose no threat to the inexorable rise and rise of stock prices. And thereas a whole industry out there devoted to persuading people that capital growth and equities are synonymous, and stocks are the only serious way to beat inflation, and all well-informed people know this, naturally. The post-war history of stock markets and property markets has encouraged these mindsets* a" though if you take off a couple of minutes or three to think about it, you will agree that the more things have done this in the past therefore the more people are convinced they will continue to do so for ever a"the less they are likely to do so in futurea because prices have been driven up in exact proportion to the conditioned expectations of those who think in this way. The people who thought that way about precious metals have had second thoughts. Gold and silver have long been the basis of money. In the old days when the two were interchangeable, the basic difference was that money earned interest and was susceptible to devaluation through inflation. This hasnat changed, following the terminal separation of currency and gold in 1971. Over very long time-spans, the price of precious metals can be expected to follow trends in general inflation and mining costs. But meana" while, if you think about it, the relations.h.i.+p of gold to money has to reflect changes in the areala interest rates, adjusted for inflation.

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 a"and not just in dollar terms. This may seem obvious, but it doesnat seem to have got through to followers of gold. Itas 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 circ.u.mstances, 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, s.h.i.+fts in real interest rates on individual currencies tend to be reflected in currency rates, producing enormous fluctuations as we all know a"meaning enormous profits and enormous losses.

As a matter of fact, the recent history of currency markets has encouraged the view that the currencies a" that means the dollar a" 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 itas 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, letas face it. The currency markets are not for those who love fantasy and self-delusion. They are, in fact, the quintessence of the azero-sum* gamea. In stock markets, when prices rise and fall, the wealth of all the partic.i.p.ants 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 partic.i.p.ants taken as a whole. A afalla in the dollar is just another way of talking about a rise in the DM, Yen, pound etc. The overall wealth cannot be changed. Weare 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 ainefficienta and can be forecast. The subsequent four chapters consider how the currencies can be forecast a"and how they canat, 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 amind-trapsa.

The abase-currencya mind-trap

The fact that currencies are money a"the money of different countries a" causes a problem with most newcomers to currency markets. A UK resident, for example, will say: aI thought I should protect myself against a fall in the pound, so I switched a 100,000 deposit into D-Marks. Should I be holding Yen?a 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 a" say D-Marks a" 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 itas relatively rare that the best of them is that X currency will rise against the pound a"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. Thatas why this book is called aThe Way of the Dollara. .Thus the relations.h.i.+p between the nondollar currencies is a residual of the basic dollar relations.h.i.+p. And the residual is not easy to a.n.a.lyse or forecast.

A professor of agriculture was questioned at a seminar: aSir, I have 200 acres in East Anglia; what do you advise me to do?a. aSow it down to barley and find a joba 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 a" and donat care.

Looking at the currency universe from the point of view of your own currency (unless itas 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 purposea" 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 doesnat 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 canat buy a currency without selling another. But if that person only gives thought to the currency being bought, and a.s.sumes 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 youave escaped from this mind-trap, then you see that what you have out there is no more than a series of price relations.h.i.+ps a" 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 Chicagoas 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 ainterbank*a market. But only a tiny proportion of the interbank business is areala risk business, generated by clients a" 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 aclearinga 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 diminis.h.i.+ng size).

There is a broad preconception that the aforward*a 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) a"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 canat go around recommending brokers. But if you want help, look up abrokera in the glossary at the end of the book.

Youall 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 donat need to pay for the currency you wish to buy: you just leave a margin of security for your bet. And you donat have to bet your s.h.i.+rt: you just bet as much or as little as you like. Meanwhile, one more obstacle.

The awhere is this currency headeda 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 canat see into the future.

Iave 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 apredicta, and regard those who do with scorn and derision?

The answer to the conundrum is quite simple a"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 a.n.a.lysing 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 awhere is this currency headed?a; and to attempt to do so is to fall into the trap. Itas only when the data are present and correcta" when most if not all of the pieces fit a"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 donat.

Letas 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 a" 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 a" 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 a" nothing wrong with that a" like alet your profits runa. We shouldnat blow it by alosing our positiona. 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 123.7a" as near as d.a.m.n it to the Y120 target. At this point CB actually admitted: aNow we donat have much basis for forecasting any more.a In truth, it didnat 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 positivea" 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 wella" 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 canat forecast, is not so easy.

But when it comes to actual trading, the ability to identify the action point is critical. In fact itas what itas 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 Bulletinas method of a.n.a.lysing the currencies is designed to identify the underlying trend and then to locate the extremes a"the points at which corrections in the main trend begin and end, including the reversal of the main trend. We canat 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 ago for ita.

CHAPTER TWO.

aNowhere is more nonsense talked than by currency experts about foreign exchange.a SIR WINSTON CHURCHILL.

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

The gla.s.s 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 a"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 Itas understandable that most of the aprosa went wrong in 1982-5. They were conditioned by history. Arenat 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 countryas 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 uncompet.i.tive; 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 aweaka currencies like the Italian lira (Lit) and the French franc (FF). By contrast certain a stronga 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.