You might conclude that speculating about events in the outside world and basing forecasts on these speculations is hazardous. You might, but it wouldn’t help you much. You might also conclude that speculating about events in the outside world and basing forecasts on these speculations is a hiding to nothing and something you should not do. That conclusion could be very helpful. That sort of speculation is what everyone is engaged in, and it does them little good. If you don’t do it, you could

be doing yourself a great favour.

In the event of a global disturbance, the dollar, it seems, can go up; and it can also go down. Obviously what we need to look at is the background of circumstances in which it is likely to go up and those in which it is more likely to go down. We can call these the set-up conditions*.

You will read in the papers – or hear from “the market-place” –that the dollar rose for “x” reason. For example:-because of a tightening in US money supply / an acceleration in the US economy –implying higher US interest rates ahead;

–because of an increase in oil prices, since oil is paid for in dollars; –because of a dip in US inflation;

–because of a blip-up in US inflation implying interest rates would need to be tightened;

–because of a better trade figure;

–because of a worse trade figure, implying US interest rates would need to be tightened;

–because of Fed intervention to support the dollar;

–because of Bundesbank intervention to support the D-Mark (punters decide to ‘take on’ the German central bank and sell the OM);

–because Currency Bulletin recommended the sale of OM!

–because the US Treasury indicated it would be happy with a higher dollar;

–because the Bundesbank said it wanted a higher D-Mark!

–because the dollar had broken through an important chart resistance level.

–because the DM had completed a reverse “head and shoulders” you name it.

That’s the financial press. The rationalisations are… well, inconsistent. By far the best reportage of market rationalisations is to be found daily in the Wall Street Journal. And the Journal is not giving its own views, but reporting those of the best-known names in the currency business –the pundits from Bankers Trust, Harris Bank, Goldman Sachs, Credit Lyonnais, Salomon Bros, Credit Suisse, BNP, Midland Montagu, Barclays Bank, Nomura and the rest.

There is an old stock exchange saying: “the market is always right”. What the pundits are quoting (many are on the dealing side, executing orders for clients), are the actual rationalisations of the participants. And these are often inconsistent. But WE, you and I, cannot base our forecasts and actions on inconsistent rationales. We would soon be wiped out if we did. We are not playing with other people’s money.

So what’s going on? In the first place, the markets, remember, turn over more than $600bn a day. The great bulk of this trading is very short term. It works something like this. Volkswagen wants to buy $700m in exchange for D-Marks. (It needs the dollars to pay bills, let’s say). It approaches a series of banks and does $5Om here and $100rn there until it has filled its needs. These banks then proceed to buy back the dollars sold to VW , and sell their excess D-Marks. This is the so-called “clearing process”* whereby supply and demand are meticulously balanced against price. Note that, at the end of the day, most banks have to have their books more or less in balance, or ‘flat’*. And during this clearing process the banks may turn over $l0 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*.