By the same token, if interest rates on the world’ s reserve currency –or any other major currency –made a sudden quantum leap, said currency was suddenly much more attractive to hold and very unattractive to borrow or to sell short (they amount to the same thing). The trouble, for the gamblers, was that you cannot forecast interest rates. As casual observers, we often think we can forecast interest rates. But full– timers know better. Anyone who could do so reliably would soon be very rich and would have no need to forecast currencies or anything else, since they would be living the life of Riley, cutting bond coupons in the South of France. The roller-coaster ride in US interest rates and the dollar in 1980 could not be forecast; and it gave the currency punting fraternity its first taste of what was to become staple fare over the next half-decade – remorseless financial bereavement.

But there was nothing in the performance of the dollar in 1980 to undermine any of the conventional wisdom of the currency markets. Sure, interest rates could dominate the dollar and make life difficult for the punters. But that was a case of “win some, lose some”. And come 1981, the punters were feeling more at home as US inflation began to come down and the US trade balance took a turn for the better. So when US interest rates took off skyward again in that year, closely followed by the greenback, many “pros” were quite quick to get on board. Though few were ready for the extent of the rise in the dollar during 1981, when it soared over DM 2.50 from the 1980 low near DM 1.80.

When the dollar backed down sharply from its highs in 1981 that was as it should be. The trouble came in 1982. The big event in 1982 was the distress of Mexico. It took Paul Volcker some time to see that his policy of very high interest rates was causing impossible strains in the world at large –south of the Rio Grande in particular. Anyway, US interest rates started coming down in mid-1982. And then things went wrong. Instead of turning down with US interest rates, the dollar carried on up. And this was the beginning of the big trouble for forex observers.

The more flexible among them had expected the dollar to fall with US interest rates and were confounded when it didn’t. The rest were near unanimous in deeming the greenback overvalued and bound to crash in the face of an inexorable rise in the US trade deficit. How could it defy the proven rules of currency behaviour –rules that had been valid throughout the experience of all participants?

It could and did. To see how, we might start by looking at what happens to dollars that pile up in the hands of foreigners as a result of a growing US trade deficit. The dollar is not just any old currency; it is the world’s money. When you get paid dollars, you don’t just automatically trade it in for your domestic currency. If you are happy with prospects for the dollar you’re likely to hang onto them. In other words, you see the dollar as a store of value, or as an investment, and judge it as you would any other investment.

This was the great discovery of the punters in the mid-1980s. The currency markets –or rather the dollar and all its main parities, DM, Yen, pound and SF – did not move in response to trade flows but to portfolio flows. It didn’t matter that it was “uncompetitive”, or “overvalued”. It didn’t matter that America’s trade account was in ruins. Investors knew all that. But what mattered to them was that it was rising, and offered the highest yields around. Just as important, America’s inflation had plunged from one of the highest

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.

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.