There is another exception to rule 1). If US interest rates are being pushed up because of a perception that US inflation is headed up, or if they fall because inflation is seen to be falling, you have another tug 0' war,between the short time-frame and the longer time-frame. To short-termers, higher rates may seem to support a currency: but over time, inflation corrupts a currency. So a movement in interest rates that is led by inflation is suspect: “real” interest rates may be unaffected, or even moving in the opposite direction.

This idea of real, inflation-adjusted interest rates may sometimes seem a bit academic. And indeed it’s a hybrid invention, for its two constituents occupy different time-frames. Interest rates can fluctuate violently over the short term: inflation can have big swings measured in years. But inflation is the one and only sufficient modulator of a currency’s value over time –any currency. Given sufficient time and/or a sufficient divergence in inflation rates, currencies do and probably must tend inexorably to follow inflation differentials in due course. We can see it happen before our eyes with the hyper-inflationary currencies: for the reserve* currencies, with their smaller inflation differentials, it’s a bit like watching plants grow.

Just as we can adjust interest for inflation to get at something closer to

the “real” picture, so we can do the same thing for currencies. It’s another academic exercise. And it’s very difficult to see how we can use “real” inflation-adjusted currency histories for any practical purpose. But it may at times be helpful for perspective. It’s difficult, for example, to look at these charts of the “real” dollar without leaping to the conclusion that the big bull market in the dollar in 1981-5 was a strange aberration in the long-term picture. In this light, the slump in the dollar from 1985 to 1987 is seen merely as a return to normal.

Although “real” yields are a hybrid, the constituents are, as it were, incestuously related. For inflation expectations are a major determinant of interest rates over time; in fact they area key determinant of long term yields all the time. Hence, the declining trend in US inflation provided as good (or better) an account of the bull market in the dollar in 1981-5 as real long-term yields.

In short, yield differentials and inflation differentials seem to be basic fundamentals of currency analysis.

As we know, the thing that makes prices move is change. And it’s axiomatic with all financial instruments that the change in question is change in expected total return. In the case of commodities, expected total return is confined to price; and the value benchmarks are usually concerned with supply and demand. In the case of bonds, total return to maturity is interest coupons plus (or minus) the difference between price and redemption value – usually “par”*: if you expect to sell before maturity, redemption value is unknown; either way, the value benchmarks are yield and the degree of certainty that interest and principal will be duly paid. Stocks fall in between: most investors nowadays focus on price, with dividend returns counting for little: still the main value benchmark is usually earning power, or the ability to payout dividends in the future.

In currencies, changes in real yield differentials are a basic value bencmark.

And I think this has been true ever since currencies began to float freely in 1973. Admittedly the professionals didn’t quite see it that way in the old days. But while we’re at it, we might as well blow their secret. The professionals made a bundle of money in the 1970s, and the way they made it was very simple. They only had two rules. One has been valid as far back as the memories of currency traders went: “sell the crisis. “When a currency got into trouble, all you needed to do was wait until the central bank came in to support it and then sell for all you were worth. It always worked: for sterling, the lira, French franc, whatever. The other rule, when the dollar went off the gold standard, was even simpler: “sell the dollar”.

Always, but especially if the central banks supported it. Following these two rules, the professional! cleaned up and the central banks lost a bundle.

In the 1980s, the roles were reversed and it was the central banks that cleaned up, with much loss of shirts among the professionals. Part of the trouble was that traders were introducing all sorts of complications into the currency equation to do with intrinsic values, and trade competitiveness; and they were obsessed with forecasting interest rates.

We know that expected total return has to be the ultimate value bench. mark for the currencies. If we know how to judge the set-up conditions tha1 precede significant moves in the dollar, and how to evaluate the back. ground of shifts in real yield differentials, we shall usually be able to spot the underlying trend in the dollar .

The key equation for turning points in currencies,

as in all financial markets, is:

extreme consensus + extreme speculation = extreme price.

During the 1980s, currency observers discovered that the currency markets resembled other markets much more closely than they had imagined. They were ruled by hope and fear. They trended more or less like other markets, and got overbought* or oversold*, just like other markets. The similarities are so great, in fact, that it’s easy to err on the side of forgetting the dissimilarities. Here are some dissimilarities.

1) The main market for the currencies is made by the world’s banks –the so-called inter-bank market* . It has no statistics. The principal vehicle for quotations is the video screen. It operates 24 hours a day.

2) The currencies are a pure zero-sum-game* , the only one in fact. It means nothing to say a currency has risen except that another has fallen.

3) The forex* markets are the only financial markets in which there is official intervention* – by central banks. No wonder: for every country but America, a rise or fall in the currency raises or lowers dollar GNP in proportion.

These differences have various implications. 1) For statistics we have to go to Chicago’s IMM, the main futures market. Although it only turns over some $10bn per day, as against a purported $6OObn+ in the interbank markets, the IMM accounts for a significant fraction of all non-bank activity, especially speculative activity. This is important, since most bank activity is merely a clearing function, i.e. just froth.

In a pure zero-sum game 2), there is no such thing as a crash. Taken as a whole, the players are never wiped out –in fact their wealth stays the same all the time. You win or lose only by playing better or worse.

Finally 3), intervention. Though those central banks are high rollers, they are swamped by the massed ranks of traders. Also there is a strange phenomenon with intervention. After the initial shock of the first round of an intervention phase, traders –especially big operators on bank dealing desks and multi-national treasury departments –seem to love “taking on”

the central banks. This means the struggle is more even than you might think, at least in the early stages of a prolonged intervention. On the basis of experience to date, I believe the following rules will payoff .