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First edition published in Great Britain in 2013
Copyright © Barbara Rockefeller and Vicki Schmelzer
978-0-85719-270-7
The right of Barbara Rockefeller and Vicki Schmelzer to be identified as the authors has been asserted in accordance with the Copyright, Design and Patents Act 1988.
British Library Cataloguing in Publication Data
A CIP catalogue record for this book can be obtained from the British Library.
All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior written permission of the Publisher. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published without the prior written consent of the Publisher.
No responsibility for loss occasioned to any person or corporate body acting or refraining to act as a result of reading material in this book can be accepted by the Publisher, by the Authors, or by the employer of the Authors.
BR
To Evangeline Hogue, English teacher extraordinaire, with my thanks
VS
To my brother Bob – I would never have come to New York and become involved in currency trading without his support
About the Authors
Barbara Rockefeller
Barbara Rockefeller is an international economist and forecaster specializing in foreign exchange. She was a pioneer in technical analysis and also in combining technical analysis with fundamental analysis. She publishes two reports daily using both techniques (www.rts-forex.com) for central banks, professional fund managers, corporate hedgers and individual traders. The trading advice newsletter has an average annual hypothetical return over 50% since inception in 1994 and has never posted a losing year. She is the author of three books on trading, including Technical Analysis for Dummies, and contributes a regular column to Currency Trader magazine. Her education includes a BA in economics from Reed College, with a year at the University of Keele in Staffordshire (UK), and MA from Columbia University in international affairs.
Vicki Schmelzer
Vicki Schmelzer has worked in the professional foreign exchange industry for over 25 years. Today she is a senior financial journalist at Market News International, with foreign exchange as her main beat. She is the creator and author of TheFXSpot a daily feature that looks at financial market happenings from the FX perspective, including fixed income, intermarket analysis, and emerging markets. Before becoming a journalist, Ms. Schmelzer worked as a senior currency dealer at major U.S. and international banks including Dresdner Bank, Citibank, Manufacturers-Hanover/Chemical Bank, and Westdeutsche Landesbank. She has appeared on ForexTV and in Alain Lasfargues’ 2009 documentary The Marvelous History of the Dollar. Her education includes a BA in German (and Mathematics minor) from Clarion State University and the study abroad program with the Goethe Institut in Staufen, Germany.
Foreword
As you will undoubtedly gather from reading the introduction to this book, foreign exchange is a complex topic. It is complex in the number of factors that impact currency valuation, it is complex in the relative weighting of these factors and it is complex in the timing of these factors. Barbara Rockefeller and Vicki Schmelzer have done a masterful job of making sense of a market that some of the best and brightest have regarded as enigmatic if not utterly incomprehensible. Much of this scepticism is driven by what the authors refer to as the perverseness of markets – the habit of currency prices to respond contrary to what fundamental analysis would suggest. Further scepticism is caused by the perceived absence of financial market theory to explain currency valuation. Additional scepticism comes from the poor track record of many market professionals in managing foreign exchange risk – some infamously. The default view is that foreign exchange markets are random and that one should hedge away any underlying currency exposure and focus on the business at hand, whether that is investing in global equities or fixed income or managing a profitable multinational corporation.
Currency hedging is very common in global markets, but it is by no means ubiquitous. The rule of thumb is that global bond investors hedge on average 80% of their foreign exchange exposure, while global equity investors hedge on average only 20% of their exposure. Much of this is due to the positive correlation between equity market performance and appreciation of the local currency. The accepted explanation is that equity markets rally during periods of relative economic strength that are accompanied by rising inflation and interest rates. The combination of these factors attracts foreign investment into the country, which lifts the value of the local currency. Furthermore, currency hedging is more common in developed markets than in emerging markets, owing to the lack of an organised futures market in many developing countries that is needed for hedging. While some players have attempted to solve this problem through proxy hedging, their track record is not particularly encouraging. Moreover, proxy hedging tends to be more expensive than many assume, particularly in the longer term. Slippage in economic and policy variables, such as inflation or interest rate differentials, ensures that no currency is a perfect proxy for another. However, as foreign exchange exposure has grown with the globalisation of asset management over the past 30 years, there has been an increasing interest in understanding currency markets. While some portfolio managers attempt to beat their benchmarks by creating alpha from actively managing foreign exchange risk, an increasing number are even trading currency as an asset class.
The absence of a widely accepted economic model for foreign exchange valuation does not imply that currencies are random any more than equity or fixed income securities are random. As in other asset classes, currency prices are driven by supply and demand. So, we should revert to the balance of payments to determine the net inflow or outflow of trade and investment. Ideally, net trade and investment flows (or what economists refer to as the broad basic balance) should be used to explain real effective exchange rate rather than spot exchange rates. Why? The value of a currency is more than simply its relative value to the US dollar or euro. Rather, it is the trade-weighted average of a given currency with its trade and investment partners. Moreover, no two countries have exactly the same level of inflation every year over the indefinite future. Consequently, we need to work with real rather than nominal exchange rates, as inflation is corrosive to the value of a currency as demonstrated by the law of one price and the theory of purchasing power parity. While this approach is relatively uncontested, it falls short of fully explaining currency price movements. Currencies are not fully floating (determined by market supply and demand), but are often subject to intervention or even active management to limit a currency’s movement over time.
There are as many foreign exchange regimes as there are countries, with only a handful truly fully floating. While major currencies such as the Japanese yen and the Swiss franc have been subject to intervention and price management recently, even the euro and US dollar have experienced market intervention over the past ten years. The reason is two-fold: first, central banks covet orderly market conditions; and second, governments prefer stable currencies to avoid threats to growth that accompany large currency movements. For