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Title: Currency Trading and Intermarket Analysis How to Profit from the Shifting Currents in Global Mar
Description: This book is called Golden Book because of the best books that benefit any beginner in the field of currency trading, which contains all the basics and the various stages

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(continued from front flap)

CURRENCY TRADING AND INTERMARKET ANALYSIS
$70
...
00 CAN

as the oil-producing nations, and the evolution of
power between the Dollar and the Euro
•

Currency trading has increased in size and speed, and
so has its impact on the global ﬁnancial scene
...

Currency Trading and Intermarket Analysis outlines
the tools needed to understand the macroeconomic
and ﬁnancial nuances of this dynamic ﬁeld and
provides you with insights that are essential to making

“Ashraf Laïdi’s book is sure to become an instant classic from Wall Street to Main Street
...
In these turbulent times, the investor
who wants to stay ahead of the curve and reap above average returns, the business
ﬁnance student who wants to get the feel of the marketplace and enrich his or her
educational experience, the international business ﬁnance professor who wants to make
the class relevant, and the policymaker who wants to engineer stable and sustained
growth must read this book and a number of times, from cover to cover
...

“A comprehensive guide to the factors that drive the FX market, with a particular emphasis
on the major currency pairs
...
His
online FX analysis has received wide following for
more than a decade, centering on G-10 currencies
the performance of a multi-FX portfolio at the United
Nations, assessed sovereign and project investment

—Susie Gharib, Anchor, PBS’s Nightly Business Report

“Ashraf Laïdi is well known to city journalists as the rising star of the currency markets
...
It is a primer on
thirty years of exchange rate drama
...
”
—Ambrose Evans-Pritchard, International Business Editor

emerging market bonds at Reuters
...
He is the
founder of AshrafLaidi
...

Jacket Design: Barsoom Design

“Ashraf Laïdi has been an invaluable source of insight as global currencies have
endured their ﬁercest bout of turbulence for years
...
”
—Peter Garnham, Currencies Correspondent, Financial Times

HOW TO PROFIT FROM
THE SHIFTING CURRENTS
IN GLOBAL MARKETS

risk for Hagler Bailly and the World Bank, and analyzed

“Ashraf Laïdi’s insights on the dollar have enlightened the millions who have seen him
on TV or read his analysis
...
Valuable information for all
investors—even the pros
...
Prior to joining CMC, Laïdi monitored

—Brad Setser, Fellow, Geoeconomics, Council on Foreign Relations

CURRENCY TRADING

And much more

—Alan Abelson, Columnist, Barron’s

LAÏDI

INTERMARKET ANALYSIS

•

A gold-based approach to valuing the major
currencies and determining their secular strengths
and weaknesses over the past decades

“Ashraf Laïdi is virtually without peer in his grasp of currency movements and their
signiﬁcance for ﬁnancial and commodity markets and the global economy
...
”

Wiley Trading

CURRENCY
TRADING and
INTERMARKET

ANALYSIS
HOW TO PROFIT
FROM THE
SHIFTING
CURRENTS IN
GLOBAL MARKETS
“For anyone eager to get a ﬁx on what makes the currency markets tick, this book is a

C

be a distinct asset class in banks’ investment

and the theories underpinning it have been widely
explored, there has been little discussion regarding the
practical intermarket relationships shaping currencies
via interest rates, equities, and commodities
...
As head FX strategist at CMC Markets—
one of the world’s leading forex/commodity brokers—
he understands the forces shaping today’s currency
market and their interplay with interest rates, equities,
and commodities
...

Following an innovative approach based on what still
works and what doesn’t in currency market analysis;
applying charts and case studies to intermarket
analysis in unprecedented ways; and weighing both
old theories and newly emerging phenomena in this
arena, Currency Trading and Intermarket Analysis
will put you in a better position to assess shifts in
economic and market dynamics and make more
proﬁtable trading decisions in the process
...
While the mechanics of the forex market

perfect introduction
...
”

ASHRAF LAÏDI
ASHRAF LAÏDI
FOREWARD BY RON INSANA

urrencies are becoming an integral part of

(continued on back flap)

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Additional Praise for
Currency Trading and
Intermarket Analysis
“Ashraf La¨di shows his deep and broad knowledge of the currency marı
kets in this book
...
”
—Ginger Szala, Publisher/Editorial Director, Futures Magazine Group
“Barron’s readers often ask if there is a book to explain to them how markets really work
...
Ashraf La¨di has produced a
ı
work that is accessible to the layperson but at the same time provides a sophisticated view of all markets—commodities, precious metals, credit, and
equities—and how they interact with the biggest market of all, currencies
...
Forsyth, Editor, Barron’s Online
“A very detailed book with an important ﬂow of information and speciﬁc
details related to some well-known periods of the USD changes
...
For sophisticated investors, they will appreciate discovering the new angles introduced in dissecting the major developments
in currencies
...
With ofﬁces in North America, Europe,
Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding
...
Whether a novice
trader, professional or somewhere in-between, these books will provide
the advice and strategies needed to prosper today and well into the future
...
Wiley
Finance
...

ii

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Currency
Trading and
Intermarket
Analysis
How to Proﬁt from the Shifting
Currents in Global Markets

¨
A SH R A F L A I DI

John Wiley & Sons, Inc
...
All rights reserved
...
, Hoboken, New Jersey
...

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, scanning, or
otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright
Act, without either the prior written permission of the Publisher, or authorization through
payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc
...
copyright
...
Requests to the Publisher for permission should be addressed to the
Permissions Department, John Wiley & Sons, Inc
...
wiley
...

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best
efforts in preparing this book, they make no representations or warranties with respect to the
accuracy or completeness of the contents of this book and speciﬁcally disclaim any implied
warranties of merchantability or ﬁtness for a particular purpose
...
The advice and strategies
contained herein may not be suitable for your situation
...
Neither the publisher nor author shall be liable for any loss of
proﬁt or any other commercial damages, including but not limited to special, incidental,
consequential, or other damages
...

Wiley also publishes its books in a variety of electronic formats
...
For more information about Wiley products,
visit our web site at www
...
com
...

Currency trading and intermarket analysis : how to proﬁt from the shifting currents in
global markets / Ashraf Laidi
...
cm
...

ISBN 978-0-470-22623-0 (cloth)
1
...
2
...
3
...

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...

HG3851
...
4 5–dc22
2008032245
Printed in the United States of America
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S
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S
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5
...
Interest rates were
regulated and low, the economy was strong and steady in the ﬁfteen years
after the end of World War II
...

Ten years later, the next, and only, time my birthday would fall on
“Good Friday,” such stability was no longer assured
...

I was ten years old and don’t remember the event
...

Within a matter of months, I recall that inﬂation became a national
issue
...

My father never made that much money to begin with, so the incipient
inﬂation that would rage another 10 years, hurt us in ways I never understood
...

Shortly thereafter came the ﬁrst of two oil shocks, wage and price controls, “Whip Inﬂation Now” buttons, and an economy so ragged and uneven
we left a dying town for the presumed land of milk and honey, California
...

O

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FOREWORD

The economic calm of my birth year had turned to chaos and nearly
ruinous chaos, at that
...

After twenty years of relative calm, from 1981 to 2001, again we ﬁnd
ourselves in a similar predicament, though with different root causes
...
S
...
A combustible mix of ﬁnancial
engineering and excess leverage has cost us dearly
...
While I am not necessarily a fan of returning to the “gold standard,” I do understand and personally appreciate the
need for a more stable global monetary system that contains and restrains
some of the more animal spirits of markets gone wild
...

We need a much more enlightened, coordinated, and concerted global
policy response to the ﬁnancial market meltdown we are now enduring
...
The currency markets are the biggest and most liquid markets in the world
...
That shock absorber is being tested today
...
Nearly half a century into my life, I
am hoping that my ten-year-old daughter and my other two children do not
have to face the wrenching dislocations I did some thirty-seven years ago,
and will instead enjoy the serene calm that existed on the day of my birth,
not the chaos that erupted just after my tenth birthday
...
S
...
With the multiyear bull markets
in stocks, bonds, and real estate having largely concluded their upward
run, global investors remain on a continuous quest for yield
...
S
...
Meanwhile, the multitude
of banks and brokerage houses offering currency trading services for investors has increasingly integrated foreign exchange into investor portfolios worldwide
...
But relatively little is written on how to explore the
practical intermarket relationships that shape currencies via interest rates,
equities, and commodities
...
While central banks aim
to manage expectations in bond and currency markets, they tend to misread such risks as asset price inﬂation and ﬁnancial market contagion, leaving professional and institutional investors wrong-footed
...
And given the plethora of media types generating constant ﬁnancial market information and advice, investors need
to separate noise from sound market and economic signals
...
It also strives to build an understanding of market risk appetite and to highlight the currency implications of the changes in riskdriven ﬂows
...
Noneconomic/market considerations, such
as geopolitical events, are also addressed in detail to explain the changing
trends in low- and high-yielding currencies
...
Anyone wishing to learn how to anticipate changes in central bank policies
and their market consequences will ﬁnd value in the chapters about yield
curves and the Federal Reserve
...

Economists, students, and market reporters seeking a comprehensive analysis of the real-life interrelationships between currencies, equities, interest
rates, and commodities will ﬁnd here a unique analysis of tried and tested
market patterns
...
S
...
The chapter also touches upon
the role of gold relative to other commodities as a preview for Chapter 8,
which is devoted to commodities supercycles
...
S
...
The major shifts in oil diplomacy and U
...
monetary policy are carefully addressed, providing incisive examination into
the evolving powers of oil-producing nations and their impact on the world
economy
...

A wide range of variables are tackled, such as national and world GDP
growth, interest rates, capital ﬂows, external balances, risk appetite, and
commodity and equity markets
...
An area of the ﬁnancial market that is seldom understood by academics but regularly tackled in trading circles, risk appetite is addressed with demonstrable examples of major shifts in volatility, corporate spreads, and currency futures
...
The chapter exposes the relationship between

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xv

short- and longer-term interest rates and how it is best applied to anticipate vital shifts in central bank decisions and turning points in economic
growth
...

Chapter 7 highlights the widening budget and current account deﬁcits
of the United States and the changing patterns of capital ﬂows ﬁnancing
these imbalances
...

Chapter 8 examines the latest commodity boom with a breakdown by
individual commodity group and the implication for currencies
...

Chapter 9 introduces diverse currency themes ranging from the historical relationship between U
...
politics and the dollar, to the cyclical evolution of commodities relative to equities
...
S
...

Currency markets have increased in size and speed and so has their impact on the global ﬁnancial scene
...

Currency Trading and Intermarket Analysis offers comprehensive tools
to maneuver through macroeconomic and ﬁnancial market nuances with
the objective of making proﬁtable decisions in foreign exchange markets
...
His command of the markets as well as his ﬂexibility to work
through the multi-themed dynamics of this book have proven invaluable for
this project
...
And thanks
also to Meg Freeborn and Laura Walsh of Wiley
...
I also thank Eric
Chang and Colin Cieszynski for always providing me the help I needed at
short notice
...
A heartfelt thanks to Sarah Mitwalli for her support
...
I extend my gratitude to John
Murphy, whose 1991 work on intermarket analysis revolutionized the allencompassing approach toward ﬁnancial markets and the global economy
...
Scheherazade Rehman and Hossein Askari for conveying their wealth of academic and practical expertise in international ﬁnance and economics in such an enthusiastic, professional, and inviting
manner
...

I

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Currency
Trading and
Intermarket
Analysis

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CHAPTER 1

Gold and
the Dollar

he relationship between gold and the dollar has long mirrored the
decades-old battle between real tangible assets and ﬁnancial assets
...
The creation of the euro in 1999 and its subsequent ascent as a credible and
strengthening currency has certainly started to challenge the dollar’s leading position among world currencies, but the euro has yet to dethrone the
greenback from its dominating perch
...

Considering the 400-year historical connection between gold and paper
currencies, the 100 years of dollar dominance, and the role of gold in initiating the present world currency order, it is appropriate to begin this book
with the evolution of the relationship between gold, the dollar, and other
currencies
...

During the ﬁnal third of the nineteenth century, most countries abandoned the silver standard in favor of a gold-based currency standard
...
As Germany adopted the deutsche

T

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CURRENCY TRADING AND INTERMARKET ANALYSIS

mark, backing it with a strict gold standard, most nations followed suit and
opted for the metal
...

The gold exchange standard ultimately saw its demise in the 1920s
when World War I disrupted trade ﬂows and the free movement of gold
...
S
...
The Act reset the value of gold at $35 per ounce from $20
...

END OF BRETTON WOODS SYSTEM
MARKS GOLD’S TAKEOFF
The Bretton Woods Agreement of 1944 launched the ﬁrst system of convertible currencies and ﬁxed exchange rates, requiring participating nations to maintain the value of their currency within a narrow margin against
the U
...
dollar and a corresponding gold rate of $35 per gold ounce
...
S
...
S
...
S
...

The surge of the Eurodollar market in the late 1960s—where international banks held U
...
dollars outside the United States—coupled with the
escalating costs of the Vietnam War led to the near depletion of U
...
gold
reserves and a devaluation of the U
...
dollar relative to gold
...
This persisted as long as the world was willing to accept
those dollars with little question
...
S
...
S
...
On August 15, 1971, Nixon shut down the
gold window, refusing to pay out any of the remaining 280 million ounces
of gold
...
1 shows the inverse relationship between gold and the
dollar since the fall of Bretton Woods
...
This triggered a rapid ascent
in the dollar value of two of the world’s most vital commodities, metals

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3

Gold and the Dollar

Gold versus U
...
Dollar Index
Jan 1971 to May 2008
1000

170

150
140

USDX

130

Staunch anti
inflation Fed policy
boosted interest
rates and USD

Soaring U
...
inflation
and tumbling US dollar
spurred gold and oil

Start of USD bear
market helps trigger
commodities boom
Plaza Accord
stabilizes
soaring USD

Strengthening equity
bull market boosts USD
and weighs on gold

900
800

9/11 attacks
reintroduce gold's
safe haven
geopolitical luster

700
600

120

500

110

400

100

300

90

200

80

Oil $/Ounce

160

USD
Gold

100

70
0
Jan-71 May-74 Sep-77 Jan-81 May-84 Sep-87 Jan-91 May-94 Sep-97 Jan-01 May-04 Sep-07

FIGURE 1
...
S
...

and oil
...
S
...
A series of devaluations in 1972 culminated in the end of the Bretton Woods
system in February 1973
...

From January 1971 to February 1973, the dollar dropped 26
...
0 percent against the British pound, and 17 percent
against the deutsche mark
...

FED TIGHTENING AND FX
INTERVENTIONS REIN IN GOLD RALLY
A series of geopolitical events coupled with rising U
...
inﬂation increased
gold prices more than ﬁvefold in the later 1970s as ﬁnancial markets sought
refuge in the security of the precious metal from the eroding value of paper

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CURRENCY TRADING AND INTERMARKET ANALYSIS

money
...
Surging social unrest in 1978 led to the 1979
hostage crisis at the U
...
Embassy in Tehran, which culminated in the overthrowing of the Shah and the Iranian Revolution
...
The Soviet invasion and occupation of
Afghanistan in December 1979 raised fears of renewed tensions between
the United States and the Soviet Union, further destabilizing the security
outlook in the region
...
But what later ensued was a testament to the importance of
economics over geopolitics in the behavior of gold
...
S
...
In October the Federal Reserve, under the new
leadership of Paul Volcker, made the historical decision to shift monetary
policy toward the targeting of money supply, away from the targeting interest rates
...
The two years of ultratight monetarism saw interest rates hit 20
percent in 1981, leaving international investors little choice but to seek the
high-yielding greenback as a way to offset double-digit inﬂation
...
2
U
...
Annual Inflation versus Gold
16
14

1200
US Inflation
Gold
1000

800
10
8

600

6

Gold $/Ounce

Annual CPI (Percent)

12

400
4
200
2
0
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970

0

FIGURE 1
...

Source: U
...
Geological Survey
...
S
...
In the ﬁrst half of the 1980s, the dollar index jumped 50 percent
while gold tumbled by the same amount to hit a six-year low
...
Those gains helped beef up national budgets and state ﬁnances
...
The gold sales helped erode the value of
the metal by 25 percent between 1995 and 1998, and lifted the U
...
dollar
against the Japanese yen and deutsche mark by 84 percent and 36 percent
respectively
...
In May 1999, gold’s decline began after the announcement from the UK Treasury that it planned to sell 415 tons of gold
...
A month later, the Swiss National Bank
(SNB) decided that gold was no longer an integral part of monetary policy making and announced the sale of half of its 2,590 tons of gold reserves over the next ﬁve or six years
...
Without any systematic limits on volume and frequency of the sales
and no coordination, central banks were free to dump gold at their own
choosing, creating sharp declines in the metal, and rapid moves in currency
markets
...
Under the agreement, the SNB sold 1,170 tons, which accounted for the bulk of the total
2,000 tons in sales by all participating central banks
...
On September 26, 1999, 15 central banks (the ECB plus the 11 founding members of

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CURRENCY TRADING AND INTERMARKET ANALYSIS

the Eurozone, Sweden, Switzerland, and the United Kingdom) announced
a collective cap on their gold sales at around 400 tonnes per year over the
next ﬁve years
...
The new arrangement raised the amount of annual gold sales
to 500 tonnes from 400 tonnes set in the original agreement
...
S
...
As of 2007, central banks held
nearly 20 percent of the worlds’ aboveground gold stocks as a reserve asset, with individual nations holding approximately 10 percent of their reserves in the metal
...
S
...
This relationship stems mainly from the fact that gold serves as
an inﬂation hedge through its metal value, while the U
...
dollar holds its
value via the interest rate commanded by it
...

Conversely, when the dollar’s exchange value rises, it takes fewer dollars
to buy gold, thereby dragging down the dollar price of gold
...

While gold’s distinction from ﬁat currencies maintains an inverse relation with currencies other than the U
...
dollar, the negative correlation
remains most striking against the U
...
dollar due to the currency’s dominance in central bank currency reserves
...
1 showed the inverse
relationship between gold and the dollar from 1970 to 2008
...
3 illustrates the highly inverse relationship between gold and the dollar between
January 1999 and May 2008, highlighting a −0
...

RECENT EXCEPTIONS TO THE
INVERSE RULE
As with all close relationships between two assets, the USD-gold relationship has not been without its temporary periods of decoupling
...
3 Monthly correlation between gold and U
...
dollar index from January
1999 to May 2008 ran as high as −0
...

striking break in the relation occurred between April and December 2005
when both gold and the dollar appreciated
...
4 shows that the correlation had run as high as 0
...
The explanation for this unusual correlation relates to developments pertaining to gold, the dollar, and the euro
...
The rally was further intensiﬁed by the 2005 revaluation of
China’s currency, which enabled it to step up appetite for gold and other
commodities
...
S
...
S
...
As the U
...
interest rate advantage over the Eurozone
was further widened by the Fed’s 2005 rate hikes, the U
...
dollar strengthened against the euro, especially as the European Central Bank maintained
rates at a historic low of 2
...

Also contributing to the dollar’s 2005 recovery was a temporary tax
break granted by the Bush administration to U
...
multinationals, allowing them to repatriate their proﬁts from their overseas subsidiaries
...
S
...
4 The gold-U
...
dollar relationship became positive in 2005 due to
higher U
...
interest rates, temporary U
...
tax incentives, and political Eurozone uncertainty, while gold rallied on strong Chinese demand
...
25 percent
...
S
...
S
...
Unsurprisingly,
the temporary inﬂows of 2005 gave the dollar its best annual performance
against the euro since 1999
...
France’s rejection of a
proposed European Union Constitution dealt a blow to conﬁdence in the
European Union and the future of its currency, particularly because France
is the second-largest economy of the Eurozone
...
A rising
euro against the U
...
dollar, for instance, may not necessarily be a reﬂection of improved fundamentals in the Eurozone but of deteriorating fundamentals, technicals, and/or sentiment in the U
...
dollar
...
Charting the euro against gold would allow for a secular view of the
euro, which is not inﬂuenced by factors speciﬁc to individual currencies
...

Charting several currencies against the price of gold presents a broader
view of currencies against a neutral asset such as gold, enabling a less biased look at the currency in question
...
5a shows the percentage
increase in the value of gold against the aussie (Australian dollar, AUD),
loonie (Canadian dollar, CAD), euro (EUR), and kiwi (New Zealand dollar,
NZD) from January 2001 to May 2008
...
The graph with
the least appreciation throughout most of the eight-year period is against
the loonie, showing that gold grew the least against the Canadian currency
...
5 percent against
the aussie versus 123 percent against the loonie, meaning gold’s appreciation was the least against the Australian dollar
...
The weaker increase
in gold against the AUD, CAD, and NZD reﬂected the broad rally in those
currencies due to their dependence on rising commodities as well as high
interest rates prevailing throughout the period
...
5b measures gold against the U
...
dollar, Swiss franc
(CHF), Japanese yen (JPY), and British pound (GBP) over the same period
...
5a, suggesting these currencies have underperformed the AUD, CAD, EUR, and NZD
...
Indeed, opportunities in foreign exchange markets are not limited solely to trading currencies against the USD, but also in those pairs involving non-USD currencies
...
This way, traders can not only determine the secular performance of currencies but may also rank them

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CURRENCY TRADING AND INTERMARKET ANALYSIS

Gold's Multicurrency Performance (Jan
...
2001 = 100)
300
250

USD
JPY

Percent

200

CHF
GBP

150
100
50
0
–50
4/20/2008

12/2/2007

7/15/2007

2/25/2007

10/8/2006

5/21/2006

1/1/2006

8/14/2005

3/27/2005

11/7/2004

6/20/2004

2/1/2004

9/14/2003

4/27/2003

12/8/2002

7/21/2002

3/3/2002

10/14/2001

5/27/2001

1/7/2001

(b)

FIGURE 1
...

in order of strength and be better able to buy the strongest against the
weakest
...
6 shows a more recent performance of gold against AUD,
GBP, JPY, and USD, measuring currencies between January 2007 and May
2008
...
2007 = 100)
70
AUD

GBP

JPY

USD

60

Percent

50
40
30
20
10
0
–10
5/25/2008

3/2/2008

12/9/2007

9/16/2007

6/24/2007

4/1/2007

1/7/2007

FIGURE 1
...

yen, which fared signiﬁcantly better than in Figure 1
...
The yen’s improvement owed primarily to the unwinding of carry trades as traders exited positions in high-yielding currencies and shifted their proceeds back to the
lower-yielding yen for safety
...

GOLD’S SECULAR PERFORMANCE
The preceding exercise enabled investors to obtain a clearer picture of currencies’ performances by valuing them against gold
...

Figure 1
...
The chart shows a gradual increase in gold’s aggregate annual growth from 1999 to 2001 before slowing the pace of growth in 2002
and 2003
...
Growth was nearly halved in 2006 to
124 percent, then edged up to 145 percent in 2007
...
7 Gold’s aggregate annual return versus AUD, CAD, CHF, EUR, GBP,
JPY, and NZD illustrate the metal’s broad performance between January 1999 and
May 2008
...

By exploring the annual growth rates in detail, we note a sensible
explanation to each of the moves
...
In those years, gold
was under the dominance of a multiyear bull market in equities founded
on low inﬂation and steady growth
...
In fact, gold prices fell
6 percent in 2000 against the greenback, concluding a nine-year market
...
This increase was
due to a combination of an ensuing bear market in U
...
and world equities as well as a general slowdown in the global economy
...

Gold went on to rally in 2002, before showing a mere 15 percent increase in 2003 and an 8 percent decline in 2004
...
The common theme in 2003 and
2004 was broad dollar weakness
...
The
rally halted in 2004 when global central banks began raising interest rates
...
Gold’s bull market extended
into 2006 and 2007 on a combination of deteriorating economic and ﬁnancial conditions in the United States and a general shift of global investor
capital into rising commodities such as gold and oil
...
7 illustrated gold’s aggregate returns over a 10-year period,
we could also use gold to compare currencies’ performances across different periods
...
8 shows how gold fared in 2000 against the eight
different currencies
...
Conversely, gold showed the highest negative performance against the USD,
followed by the CAD, which helps traders conclude that the USD was the

2000 Gold Returns versus Various Currencies
NZD
AUD
CHF
JPY
GBP
EUR
CAD
USD
−10%

−5%

0%

5%

10%

15%

20%

25%

FIGURE 1
...

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CURRENCY TRADING AND INTERMARKET ANALYSIS

2007 Gold Returns versus Various Currencies
USD
GBP
JPY
CHF
EUR
AUD
CAD
NZD
0%

5%

10%

15%

20%

25%

30%

FIGURE 1
...

highest-performing currency against all other currencies, with the CAD in
second place
...
A few exceptions have
occurred, such as in 2000 when the Swiss franc fared as the third-worst
underperformer against gold due to the Swiss National Bank’s sales of its
bullion
...
S
...

Fast-forwarding seven years ahead, we ﬁnd a largely different picture
for gold in 2007
...
Put in
another way, the 2007 relative performance of currencies was the near opposite of 2000, dominated by the commodity boom as well as commodity
currencies
...
S
...
(See Figure 1
...
)

GOLDEN CORRELATIONS
The inverse relationship between gold and the U
...
dollar has implied a
generally positive relationship between gold and currencies whose correlation with the dollar has the highest negative correlation
...
S
...
And because the Eurozone is the world’s second
largest economy after the United States, its currency is most apt to act as
the anti-dollar, rallying at the expense of the greenback and selling off to
its beneﬁt
...
10 illustrates the six-month gold correlations with the dollar index, the aussie, the euro, the yen, and New Zealand dollar from
January 2002 to May 2008
...
53
...
53
each, with the former acting as the anti-dollar and the latter correlating with its vast mining industry
...
39
...
78 over the last four months of the measured period
...
43
...
But the correlation between the agriculturedependent currency and gold proves insufﬁcient to last through most of the
seven-year period
...
0
0
...
0
−0
...
0
−1
...
10 Gold’s correlations are highest with Aussie and Euro
...
But, as is explored in more detail in Chapter 8, the gold
rally has been founded considerably on major supply and demand conditions
...

Simply mentioning falling production as a reason is not enough for
addressing factors behind the bull market in gold
...
World gold production fell more than 1
percent to 2,444 tons in 2007, reaching its lowest level since 2004
...
In 2007 alone, South African
production fell 8 percent to 272 tons of gold, dropping to second place for
the ﬁrst time since 1905, according to GFMS
...
China went from
producing 71 tons in 1988 to 134 tons in 1998 and to 276 tons in 2007
...
11
...
S
...
Similarly, gold can fulﬁll the
same purpose for major stock indexes
...
S
...
As in the previous

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17

Gold and the Dollar

World Gold Production
2,650

Metric Tons

2,600
2,550
2,500
2,450
2,400
2,350
1998 1999 2000 2001 2002 2003 2004 2005 2006

FIGURE 1
...

Source: U
...
Geological Survey (http://www
...
com/production
...

exercise with currencies, pricing the major stock averages in terms of gold
enables a truer perspective for equities because they are compared against
the currency of gold, whose value is solely inﬂuenced by natural forces of
supply and demand and cannot be manipulated by any issuing authority as
is done to national currencies by their central banks
...
By comparing gold with equities,
we assess the two most popular measures of corporate market value seen
in the major equity indexes (stock indexes) to a classic measure of real
asset value (gold)
...
Figure 1
...
The beginning
of the period occurred near the start of the bull market in gold while coinciding with the intensiﬁcation of the bear market in equities
...
But note that since their peak in October 2007, both
the S&P 500 and the Dow have dropped nearly 20 percent, while gold rose
by 50 percent over the same seven-month period
...
13 compares their performances between January 1997 and May 2008
...
What followed was a four-year inverse relationship

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CURRENCY TRADING AND INTERMARKET ANALYSIS

Change in Gold, Dow, and S&P 500
(Jan
...
12 Gold rose 10 times faster than the S&P 500 and Dow Jones Industrial Average between January 2002 and May 2008
...
13 Although equities recovered from the 2000–2002 bear market,
their gains paled compared to gold’s recovery
...
When the U
...
and
global economies recovered by the end of 2003, both equities and gold
advanced higher, with the metal rising at a growth rate 10 times faster
than equities
...
Having compared the growth
of gold relative to equities, we now look at the two in relative terms by examining the equity/gold ratio
...

Gold is known to measure real asset value because of its ability to preserve value during inﬂationary times
...
12 and
1
...
Figure 1
...
Both ratios have fallen more than 200 percent off their 1999 peak,
which occurred when gold hit its 20-year lows and equities reached their
highs at the top of the dot-com bubble
...
Following each of these three
peaks, stocks fell in a multiyear sell-off, accompanied by a rally in gold
...
14 The plunge in the equity/gold ratio reﬂects the overall recovery in
tangible versus monetary assets
...
But as
we saw earlier, stocks’ 2003–2007 recovery did not prevent the equity/gold
rally from extending its decline due to the accelerating advances in gold
...
15
...
If this pattern holds into the future, then
the equity/gold ratio has further declines ahead of it until recapturing the
lows of the early 1980s
...
Chapter 8
makes the case for a prolonged increase in the current commodities boom,
in which gold will likely play a considerable role
...
Accordingly, prolonged declines in the equity/gold ratio will also imply that the real-asset values of
tangibles such as metals, energy, and agriculture/food products will maintain their upward trajectory
...

Dow/Gold, S&P 500/Gold Ratios
22
SP/Gold
Dow/Gold

2
...
2

16

1
...
0

14

1
...
2

3/18/2007

12

1/7/2007

1
...
15 The equity/gold ratio recovered from its lows of March 2008, but
the fundamentals underpinning commodities relative to equities suggest a limited
rebound
...
Just as we have seen the ratio of major equity indexes to the price of
gold falling to 13-year lows in late 2007, the ratio of total ﬁnancial assets to
physical gold is near the low end of its historical range
...
Note how this difference in magnitude
is similar to the aforementioned difference between the gold/equity ratio
as of May 2008 and that of 1980, which was also four to ﬁve times greater
...
Chapter 8
is devoted strictly to the fundamentals underpinning the rise in gold and
metals as well as energy and agricultural commodities
...

Figure 1
...
16 Speculators in gold futures contracts have helped boost gold prices
but are not the main driver to the rally
...

Note, however, toward the end of the chart how the amount of interest
plummeted from a record high of 201,859 net long contracts (more buyers than sellers) in October 2007 to an eight-year high of 74,343 net short
contracts (more sellers than buyers) in January 2008
...
Thus, although the speculators have signiﬁcantly curtailed their long positions, they could not reverse the price action in the metal, which was boosted by such events as the assassination of
former Pakistani Prime Minister Benazir Bhutto, renewed erosion in U
...

and global ﬁnancial markets over subprime loans in the United States, and
aggressive interest rate cuts by the Federal Reserve
...
Figure 1
...
Note how the gold rally preceded all other commodities, starting as early as the third quarter of 2001 before accelerating its
advances in the ﬁrst quarter of 2002 once the dollar had peaked
...
The relationship between oil and the dollar is
discussed in more detail in Chapter 2
...
Thus, if a rally in gold
is accompanied by other commodity groups, as was the case in 2003, 2004,
and 2007, then the U
...
dollar is more likely to be subject to broader secular pressure
...

The expansion of global foreign exchange markets, along with the
emergence of a new array of several economies from the developed and developing world, has given rise to a multitude of new currencies to be traded
by institutional as well as individual players
...
Using gold as a common denominator measure of a group of

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Gold and the Dollar

Gold's Rally Preceded Other Commodities (Jan
...
17 Gold’s bull market preceded other commodities by nearly a year,
before the dollar decline triggered a more universal rally in commodities
...
For contrarian investors preferring to
pick up trends before they occur, a similar exercise may be used to buy and
sell currencies near the top and bottom of the ranking of returns
...

Global ﬁnancial markets have become more interconnected than they
ever were in the past
...

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CHAPTER 2

Oil Fundamentals
in the Currency
Market

he relationship between the most sought-after energy form and the
world’s reserve currency has invariably evolved via the intermediation of world economic growth and its response to energy prices
...

As those recessions impacted the U
...
economy, the dollar came under
pressure
...
As this chapter will demonstrate, the tumbling dollar was a key factor
in oil producers’ decision to raise oil prices during the early 1970s in order
to cushion the impact of a falling purchasing power as the weak currency
eroded the value of their dollar-denominated oil receipts
...
As the Federal Reserve rushed to increase interest rates to counter the inﬂationary costs of high energy prices,
U
...
yields gained in attractiveness, prompting the sharpest U
...
dollar rally
in history
...
The arrival of alternative sources of energy, the rise of economic powers in the developing world, and the convergence of global economies via capital ﬂows contributed to changes in the demand/supply equation for oil as well as its inﬂuence on different economies, whose currencies ﬂuctuated signiﬁcantly
against the greenback
...
S
...
S
...
1 The inverse relationship between the U
...
dollar and oil was most
striking during periods of protracted uptrends or downtrends in oil
...
Finally, we will look at the relationship
between the price of gold and oil over the past 30 years and how it helps
investors assess the implications for the U
...
economy, interest rates, and
the dollar (see Figure 2
...

FROM A GOLD STANDARD TO AN OIL
STANDARD (1970s–1980s)
The decline in the value of the dollar following the 1971 collapse of the
gold-dollar exchange standard set up in Bretton Woods in 1944 played
a vital role in fueling the upward spiral in oil prices of the ﬁrst half of
the 1970s
...
The conversions were done at
the ﬁxed price of gold of US$35 per ounce
...
00 per barrel
...
S
...
S
...
Oil producers were forced to convert their excess U
...
dollars by purchasing gold in the marketplace, driving both the fuel and the
metal higher and sending the value of the dollar lower
...
From January 1971 to July 1973, the dollar index (measured
against a basket of six currencies) lost 25 percent of its value, prompting
the Organization of the Petroleum Exporting Countries (OPEC) to initiate
its ﬁrst price-boosting campaign
...
By the time the embargo
was lifted against the United States in March 1974, oil prices had quadrupled to nearly $12 per barrel, triggering a global economic slowdown and
inﬂation over the next three years
...
S
...
S
...
While the
Bretton Woods era of the 1950s to 1960s was known as the gold-backed
standard, the 1970s and 1980s ushered in a de facto oil-dollar standard
...
Unlike in the 1950s to 1960s when oil prices remained steady below
$2
...

Oil Price Shocks Fueled by Mounting Inﬂation,
Falling Dollar
Up to this day, many still attribute the quadrupling of oil prices in 1974
to OPEC’s oil embargo and its increased political dominance
...
S
...
Recall that the pressure on
the dollar escalated as early as the late 1960s when the cost of ﬁnancing the
Vietnam War and the Cold War drove up the balance of payments deﬁcit
...
S
...
Nixon’s decision to shut the gold window in August

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CURRENCY TRADING AND INTERMARKET ANALYSIS

1971 ended the dollar’s convertibility onto gold, prompting a collapse in
the international ﬁnancial system that was based on conﬁdence in the U
...

dollar
...
2 per ounce
...
The
dollar became freely traded and freely sold
...
0 percent against the yen, 4
...

First Oil Shock (1973–1974)
As the dollar tumbled in world markets, OPEC suffered from two fronts:
being paid in a rapidly depreciating U
...
dollar, and facing higher costs of
its imports as world inﬂation pushed up prices for commodities and industrialized goods
...
S
...
2 percent in 1968 from 2
...
In 1969 inﬂation hit
5
...
2 percent in 1970
...
S
...

No surprise that in early December 1970, the oil cartel began its ﬁrst
formal discussions about price increases, resulting from changes in foreign
exchange rates
...
S
...
At its 1970 annual conference,
OPEC passed a resolution expressing concern about “worldwide inﬂation
and the ever widening gap existing between the prices of capital and manufactured goods and those of petroleum
...
In 1971, 1972, and 1973, oil
producers increased prices by 2
...
5 percent, and 5
...

One cannot assess the inﬂationary pressures triggering OPEC’s price
hikes in 1971 without addressing the expansive monetary policy pursued
under the Fed Chairmanship of Arthur Burns
...
Burns had also served as a cabinet-rank counselor to the president on all economic issues for the year before becoming chairman of
the independent Federal Reserve
...
The inﬂationary consequences of those policies have played an
unequivocally major role in the U
...
failure to maintain a ﬁxed exchange

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29

Oil Fundamentals in the Currency Market

rate regime against gold, eventually triggering the devaluation of the U
...

currency
...
2 illustrates how Arthur Burns’ easing monetary policy drove
U
...
interest rates below those of the rest of the world, thus reducing the
yield reward of the U
...
dollar and eroding 10 percent from its value between 1971 and 1972
...

Against the backdrop of rising oil prices and a falling U
...
dollar in
the ﬁrst 2
...
Between 1973 and 1974, oil rose
fourfold to nearly $12 per barrel, prompting sharp run-ups in U
...
gasoline
prices and an abrupt decline in consumer demand
...
3 percent in major industrial economies, from 3
...
In
1974, U
...
inﬂation soared to 11
...
7 percent, from 7
...
In 1974–1975,
the U
...
and major industrialized economies descended into recession
...
S
...
3 percent in 1974, the dollar began a
gradual rebound from March 1975 to May 1976, coinciding with a global
recovery after nearly two years of recession
...
S
...
2 Easing U
...
monetary policy in 1970–1972 played a major role in the
U
...
dollar’s decline, stirring up inﬂation and encouraging OPEC to boost oil prices
...
3 percent increase in U
...
growth
...
The notable rise versus the pound was especially
driven by soaring inﬂation in the United Kingdom, lifting the retail price
index by as high as 27
...

The First Dollar Crisis (1977–1979)
The U
...
dollar rebound of the mid-1970s came to a halt in summer 1976
...

Jimmy Carter’s presidential campaign against Gerald Ford sought to lift
the U
...
economy from its slowdown in the second half of 1976
...
S
...
The slide was accelerated in June 1977 when Blumenthal talked down the dollar after a meeting with his German and Japanese counterparts
...
Figure 2
...
S
...
3 U
...
dollar drops nearly 40 percent against the Japanese yen as U
...

oﬃcials talk down the currency
...
Figure 2
...
S
...

The dollar crisis was a vociferous manifestation of eroding market
conﬁdence in Carter’s economic policies despite the fact that U
...
interest rates were yielding substantially more than those overseas
...
From summer 1977 to autumn 1978, U
...
interest
rates nearly doubled from 5
...
5 percent
...
5 to 3
...
5 percent,
respectively, tripling the yield advantage in favor of the U
...
dollar
...
S
...
9 percent unemployment rate, following the stagﬂation days of the Ford administration
where unemployment breached 9 percent and inﬂation crossed over 11 percent
...
Inevitably, conﬁdence in the dollar continued
to erode
...
S
...
4 The 22 percent decline in the U
...
dollar index was less pronounced
than the dollar’s damage against the yen, as Japan’s expanding trade surplus was a
boon for the currency
...
The
move was supplemented with a 100-basis-point increase in the discount
rate, the biggest in 45 years
...
S
...
It wasn’t until the Fed rewrote the rules of
monetary policy management to combat soaring inﬂation in late 1978 that
the currency began to turn around
...
Oil prices had averaged about $12 per barrel partly
due to a ﬁrm dollar in 1976 and early 1977, while major industrialized
economies averaged annual growth rates at a brisk 5 percent accompanied
by lower levels of inﬂation from the 1974–1975 period
...
Surging social unrest in the second half of 1978 led to heated protests against
the U
...
-backed Shah regime, culminating in the hostage crisis of the U
...

Embassy in Tehran and the Iranian Revolution of February 1979
...
S
...
Just as in 1973–1974, the oil shock of 1979–1980 would
trigger soaring inﬂation rates, which eventually eroded GDP growth, sending the world into recession
...
5, where the three major oil shocks (1973–1974, 1978–1980, and the
ﬁrst Gulf War of 1989–1990) prompted the recurring pattern of mounting
inﬂation followed by a contraction in economic growth
...
Geopolitics
again played a role, but this time the price impact was negative
...
But Saudi Arabia, the biggest producer, ﬂooded the
world market with inexpensive oil in 1981 and on into the mid-1980s, raising production to make up for the loss of Iranian and Iraqi production
...
5 The pattern of soaring inﬂation rates followed by contractionary
shocks in G7 economies (United States, Japan, Germany, Canada, United Kingdom,
France, and Italy) was consistent throughout the three oil shocks, denoted in shaded
areas
...
Figure 2
...

The other main reason for OPEC’s concerted price cuts was the gradual collapse of the world economy in 1980–1982
...
S
...
The double whammy of escalating import and oil
prices triggered double-digit inﬂation in Europe and Japan, causing their
central banks to embark on aggressive rate hikes at a time of already slowing growth and rising unemployment
...

Global demand plummeted and so did consumption
...
6 The 1978–1981 oil price shock triggered renewed inﬂation, causing
the U
...
Federal Reserve to respond with soaring interest rates, eventually boosting
the value of the U
...
dollar and raising the import burden on nations whose currencies
are falling against the greenback
...

prices was fast and deep
...
7 illustrates the prominent decline in
global oil demand from 1980 to 1984, which played a signiﬁcant role in exacerbating the price plunge
...
The emergence of cheaper alternatives to OPEC oil in the
Alaskan and North Sea ﬁelds was also a factor in curtailing demand for the
OPEC substance and its price
...
7 After peaking in 1979, oil demand headed for a four-year decline as
central banks pushed interest rates to double digits to ﬁght soaring inﬂation from
the 1978–1980 oil price shock, driving the world economy into recession
...
S
...
Although oil prices fell 75
percent between 1981 and 1986, the decline followed a 200 percent price
jump in 1979–1980, which was largely caused by the 20 percent slide in
the dollar
...

Aside from OPEC’s oil spikes, inﬂation was also provoked by the
Vietnam War, Lyndon Johnson’s ﬁscal expansion to stimulate the Great
Society, increased wage demands from labor unions that went beyond productivity growth, and ﬁnally the Federal Reserve’s excessive pump-priming
under the government-friendly Chairman Arthur Burns
...
3
percent, 13
...
4 percent in 1979, 1980, and 1981 respectively
...
5 percent, 12
...
2 percent
...
It took two
months before the Federal Reserve realized the urgency of adopting drastic
measures to ﬁght the destructive effects of an ever-growing price problem

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CURRENCY TRADING AND INTERMARKET ANALYSIS

on incomes and purchasing power
...
5 to 4
...
In autumn 1979, inﬂation hit 13 percent, surpassing the highs of 1974 and attaining levels not seen in 32 years
...
9 percent, and M-1 (the basic
aggregate of monetary spending) hit 8
...

In October 1979, the Federal Reserve made a historical policy shift by
adopting a new operating system of targeting money supply rather than
interest rates
...

Weeks after the Fed made its change, the Fed funds rate jumped to 17 percent in one day, dropped to 14 percent the next day, before rebounding
again to 17 percent and back down to 10 percent
...

As U
...
interest rates soared well above those in the industrialized
world, so did demand for the greenback, resulting from global investors
seeking higher-yielding returns to offset double-digit inﬂation rates
...
S
...

One dollar bought 238
...
45 yen ﬁve years later
...
7245 marks to 3
...

Figure 2
...
S
...
As the 1981 oil price peak culminated into broad interest rate cuts in Europe and Japan, their currencies
were dragged down against the greenback
...
S
...
S
...

The U
...
dollar’s interest rate differential relative to the rest of the
world played a major role in the dollar’s ascent
...
S
...
5 percent compared to 7
...
20 percent in Japan
...
S
...
S
...
5 percent and 9
...
After a temporary drop to 8
...
S
...
Renewed
policy tightening once again lifted U
...
rates to twice the level in Germany
and Japan as their central banks stopped raising their interest rates
...

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Oil Fundamentals in the Currency Market

USD Performance versus Major Currencies (Jan
...
8 The U
...
dollar soared during the ﬁrst half of the 1980s due to higher
U
...
interest rates and struggling economies suﬀering from the high dollar cost of
oil imports
...
9 illustrates the role of the widening U
...
interest rate advantage in spurring the U
...
dollar’s recovery
...
S
...

The Federal Reserve’s tightening policy shifted toward targeting money
supply, while letting interest rates double to 20 percent
...
S
...

The 1979–1980 inﬂationary spiral forced major central banks into doubling their interest rates, and the world economy came to an abrupt halt in
early 1981
...

The economic treatment of Paul Volcker’s two-year dosage of hard monetary medicine succeeded in vanquishing inﬂation from its 30-year highs,
but at the expense of a two-year recession that sent unemployment to a
postwar high of 10
...

As the recession deepened in 1980–1981 and inﬂation peaked by the
end of 1980, the Fed began a three-year easing campaign, slashing rates
from 20 percent in May 1981 to 3 percent in February 1984
...
The more

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CURRENCY TRADING AND INTERMARKET ANALYSIS

U
...
Dollar's Response to U
...
Yield Differentials
14
US-Jap/Ger Avg
USD

160

10

150

8

140

6

130

4

120

2

110

0

100

−2

90

−4
Jan-79

Jan-80

Jan-81

Jan-82

Jan-83

Jan-84

Jan-85

Jan-86

USD

Rate Differential (Percent)

12

170

80

FIGURE 2
...
S
...
The USD Index is plotted against a graph representing the Fed funds rate
minus the average rate of Japanese and West German interest rates
...

To the rest of the world, the soaring dollar meant falling currencies
and rising inﬂation
...
As the dollar strengthened,
nations had to spend more of their depreciating currencies to import highdollar-priced goods
...
Already in a
campaign to ﬁght the inﬂationary pressures of soaring oil, West Germany
further raised rates from 3
...
5 percent in 1980, causing a two-year contraction in economic growth, which included a doubling
of unemployment to 2
...
Of the unemployed 32 million in
OECD nations, half were from Europe
...
But GDP growth did enter the range of a growth
recession, which is deﬁned as a growth rate below 3 percent
...
S
...
The U
...
trade gap moved sharply into a deﬁcit and millions of
manufacturing jobs were lost
...

After 10 ineffective attempts of currency intervention aimed at stabilizing the dollar between 1981 and early 1985, the world’s ﬁve biggest
economies waged a global coordinated campaign to reverse the dollar’s
ascent
...
The decline was especially helped
by Fed rate cuts in the second half of 1984 while rates remained unchanged
in West Germany and Japan, and rising in the United Kingdom
...
In September 1985 at the Plaza
Hotel in New York, representatives from the Group of Five (United States,
Japan, Germany, United Kingdom, and France) agreed on coordinated operations to support non-U
...
dollar currencies
...
The interventions
worked: The dollar lost 20 percent from September to December 1985,
before shedding another 27 percent in 1986
...
As
the oil price drop of the mid-1980s intensiﬁed—resulting from slumping
world demand and OPEC’s price declines—oil importing nations beneﬁted
signiﬁcantly over time
...
S
...
In
the early 1980s, West Germany and Japan were the two countries with the
highest dependence on imported oil as measured in terms of their overall
economy
...
10 shows Japan to have moved from being highly oilimport-dependent during the early 1980s—with an oil import/GNP ratio of
5
...
An expanding Japanese economy and a strong yen were major

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CURRENCY TRADING AND INTERMARKET ANALYSIS

Japan's Oil Dependence Was Highest But Fell the Sharpest
6
Japan
USA
West Germany

Oil Imports/GNP

5

4

3

2

1

0
1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

1972

FIGURE 2
...

contributors in reducing the relative value of oil imports
...

As concerted dollar-selling intervention took full force in autumn 1985,
so did the decline in the currency
...
The
windfall on these economies’ external trade balance was especially ampliﬁed by the 1986 decline in oil prices
...
Their imports
fell relative to their exports, triggering a vital ﬂip to their overall growth and
further boosting their currencies
...
11)
...
Consequently, the windfalls of the oil price
plunge were manifested more strikingly in Japan and West Germany than
in the United Kingdom
...
Against
the backdrop of the 1986 plunge in oil prices, the British pound edged up

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Oil Fundamentals in the Currency Market

Currencies' Change versus U
...
Dollar During Falling Oil
25%

25
DEM
GBP

20%

JPY
Oil

20

15
10%
10

Oil $/Barrel

FX Change

15%

5%
5

0%
–5%

0
Dec-86

Nov-86

Oct-86

Sep-86

Aug-86

Jul-86

Jun-86

May-86

Apr-86

Mar-86

Feb-86

Jan-86

FIGURE 2
...
S
...

3 percent against the dollar, while the deutsche mark and the Japanese yen
both soared 21 percent
...
S
...
By the end of 1987, the currency lost all
of the gains incurred at the ﬁrst half of the decade
...
The
Louvre Accord of February 1987 was reached to stabilize the falling dollar
and help other countries halt costly appreciations in their currencies
...

IRAQ’S INVASION OF KUWAIT AND
THE GULF WAR (1990–1991)
On August 2, 1990, Iraq’s invasion of Kuwait gave oil prices their sharpest
percentage increase over any two-month period, lifting them by 48 percent
to $41 per barrel in October 1990 from their $15 per barrel mark in June

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CURRENCY TRADING AND INTERMARKET ANALYSIS

1990
...
59 million barrels of Kuwait oil was cut off from world production, or 0
...
It took over ﬁve months for
the Gulf crisis to turn into the outbreak of the Gulf War on January 17, 1991
...
S
...

As in most geopolitical conﬂicts involving oil, prices make their biggest
jumps during the period leading to war when the risk of the unknown triggers fears of uncertainty regarding the fate of oil supplies
...
70 per barrel on the day of the August 2, 1990, invasion to over
$40 per barrel in mid-October, before heading mostly lower the rest of the
year and into the war outbreak of January 1991
...

After having reduced production by an annual average of 40 percent during
the 1980s, Saudi Arabia hiked production by 27 percent in both 1990 and
1991, attaining a 10-year high of 8 million barrels per day
...
S
...
Savings and loans had been struggling to balance the rising cost
of their liabilities with the falling portfolios of their mortgage assets
...
Real estate prices tumbled across the board and the economy
slowed sharply
...
0 percent from
4
...
Soaring oil prices of summer 1990 exacerbated the slowdown and sent the economy into recession from third quarter 1990 to second quarter 1991
...
Diverging global interest rates and a stalling U
...
economy dragged the dollar down by 15 percent from early 1990 to summer
1991
...
S
...
S
...

Figure 2
...
S
...
As oil prices broke the $30 per barrel mark, the
dollar’s declines accelerated amid protracted risks for the already slowing
U
...
economy
...
Note how oil prices declined sharply on the day
the war broke (second shaded column) with the rationale being that the

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Oil Fundamentals in the Currency Market

USD Change after Iraq 1990 Invasion of Kuwait,
War Outbreak, and Cease-fire
$47

20%
USD change vs
...
CHF

$42

USD Change versus FX

Oil price

10%
$37
5%
$32
0%
$27
−5%
$22

−10%
−15%
−187 −172 −158 −143 −129 −114 −99 −84 −70 −55 −40 −25 −11 4

18

33

50

65

$17

Number of Days Before and After War

FIGURE 2
...
S
...

conﬂict would come to a quick end and oil supplies would be secure
...

Another main factor weighing on the U
...
dollar was foreign selling
of U
...
equities
...
S
...
S
...
S
...
The
selling intensiﬁed in summer August 1990 when the invasion of Kuwait increased geopolitical uncertainty and drove oil prices sharply higher
...
S
...
S
...
S
...
S
...
But once the cease-ﬁre
was announced on February 28, 1991, oil prices had dropped by more than
50 percent from their $41 high and the dollar pared all its postwar losses
against major currencies
...
13 shows the sharp decline in net purchases of U
...
equities
in the months of the Iraqi invasion, dropping from a net buying balance of
$1
...
8 billion in net selling in October
...
S
...
S
...
S
...
13 The decline in net foreign purchases of U
...
stocks upon the
August 1990 Iraqi invasion of Kuwait was greater than that in U
...
Treasuries, but
the rebound was more prolonged after the February 1991 cease-ﬁre
...
Although
U
...
Treasuries involved greater dollar amounts in capital ﬂows, their behavior was more volatile after the cease-ﬁre due to the combination of the
competing returns from stocks and global bond portfolio redistribution
...
Oil prices had doubled between 1994 and 1996,
thanks to a combination of oil workers’ strikes disrupting production in
Nigeria, extremely cold weather in the United States and Europe, and the
strike of U
...
cruise missiles into southern Iraq following an Iraqi invasion
of Kurdish safe-haven areas in northern Iraq
...
22 per barrel, its highest level since the 1991 Gulf War
...
But the oil price decline was interrupted
in summer 1997 when Iraq refused United Nations weapons inspectors admission into key sites, raising fears of a renewed conﬂict in the Middle East
...
5 million barrels per day to 27
...
OPEC’s
10 percent production increase drove up total world output by 3
...

Figure 2
...

Economies in newly industrial Asian countries (Hong Kong, South Korea,
Singapore, and Taiwan) saw their GDP growth drop from 4
...
6 percent in 1997, while total domestic demand plummeted
from 4 percent in 1997 to −9
...
Unemployment growth
went from 2
...
7 percent in 1998, and import volumes tumbled 8
...
1 percent in 1993–2002
...
Sharp currency
depreciations, soaring interest rates, and political unrest damaged domestic demand
...
Oil
prices continued to plummet as increased production from Iraq coincided
with zero growth in Asian oil demand due to the Asian crisis and escalating
oil inventories
...
40 per barrel in December 1998, losing
60 percent from their December 1996 high
...
14 The sharp tumble in Asian economic growth exacerbated the
1997–1998 decline in oil prices, but the recovery in subsequent years was swift in
both growth and prices
...
S
...
Beginning in 1996, U
...
interest rates were higher than those in Germany (and later the Eurozone after
1999) and Japan
...
The global tech rally
powered by the Internet bubble was a boon for U
...
After averaging a monthly drop of 99 percent and 134 percent in
1996 and 1997 respectively, growth of net foreign purchases of U
...
equities rose 1,448 percent, 59 percent, and 34 percent in 1998, 1999, and 2000
respectively
...

The period 1999–2000 proved a rare example of a broadening global
expansion feeding into higher demand for the fuel
...
2 percent between 1980 and 1998,
broke the 3 percent growth mark in 1999 and 2000, registering the ﬁrst 3
percent handle in nine years
...
40 per barrel in
December 1998 to a high of $30
...

The burst of the technology bubble in 2000 culminated in a prolonged
worldwide stock market decline, which was further exacerbated by the
September 11 attacks the following year
...
S
...
5 percent in 2001
from 4
...
Growth in advanced economies cooled down to
1
...
U
...
oil demand slowed to 0
...
3 percent in 2001
...

IRAQ WAR FUELS OIL RALLY, DOLLAR
FLOUNDERS, CHINA TAKES OVER
(2002 TO PRESENT)
The 2001–2002 economic slowdown proved only temporary
...
S
...
By the outbreak of war in March 2003, oil prices had
doubled to $35 per barrel from their December 2001 lows
...
Global unemployment started heading lower, while
rallying stock markets and improved balance sheets spurred household
conﬁdence and spending
...
S
...
51, just short of
its 15-year highs attained six months earlier
...
It was no coincidence that
the dollar’s peak of spring 2002 coincided with President Bush’s trade war
action of slapping foreign steel producers with tariffs in order to secure
the Republican Party victory in key states ahead of the Congressional elections later that year
...
S
...

The message was also loud enough for currency traders to begin selling
the dollar against all major currencies, including the euro, which had become an obligatory legal tender in the Eurozone that year
...
S
...
More is discussed on the geopolitical dynamics of the currency market in Chapter 9
...
S
...
With the Fed funds
rate reaching a 45-year low of 1 percent in June 2003, U
...
short-term rates
were the lowest in the industrialized world with the exception of Japan
and Switzerland
...
S
...
The Fed’s rate hikes of 2004–2005 gave the U
...
dollar a
prolonged reprieve in 2005, before renewed selling eroded the currency’s
value in 2006 and 2007
...
15 shows the clear inverse relationship between the U
...
dollar (bottom graph) and oil and gold prices (top graph) between 2002 and
2007
...
S
...
Gold surged 290
percent from its 2002 low to breach the $800 per ounce mark in later 2007
...
Metals, fuels, and agricultural commodities woke up from their
1990s slump as their currency of exchange, the dollar, began its secular
bear market
...

China’s energy appetite was also a major factor in escalating commodity demand
...
The resulting

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CURRENCY TRADING AND INTERMARKET ANALYSIS

USD versus Gold and Oil (Jan
...
15 The 40 percent decline in the U
...
dollar index during 2002–2007
was closely correlated with the surging prices of oil and gold
...

China’s growth rate has become synonymous with global demand
for commodities
...
16 shows that China’s oil demand stood at
China versus Total World Oil Consumption
10

88
China Oil Consumption (Left Scale)
World Oil Consumption (Right Scale)

9

Chinese demand as percentage
of world total
7
...
2%

84

7
...
3%

5

6
...
8%

80

4

78

$ Billion per Barrel

$ Billion per Barrel

86

8
...
90%

3
76
2
74

1
0

72
2000

2001

2002

2003

2004

2005

2006

2007

FIGURE 2
...

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49

4
...
8 percent of the world’s total
...
8 percent in 2004,
beating Japan to second place behind the United States
...
With GDP growth topping 11 percent in 2007, elusive signs
of an economic slowdown have yet to weigh on commodities
...
5
trillion should maintain the country’s support for commodities prices
...
The years 1976–1979, 1994–1997, 1999–2000, and
2003–2006 were all periods of steady import demand sustained by robust
growth in both the developed and developing world
...

The United States remains the world’s biggest economy as well as the
world’s biggest oil consumer
...

Given that the United States imports 58 percent of the oil it consumes,
the cost implications are considerable, especially given that dependence
on foreign oil has risen from about 36 percent in the ﬁrst and second oil
crises, and is expected to reach 68 percent in 2025
...
S
...
As a share of the trade deﬁcit, petroleum
imports surged from 25 percent to 40 percent of the U
...
trade imbalance
...
S
...

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CHAPTER 3

When the Dollar
Was King
(1999–2001)

etermining why foreign exchange rates move the way they do may
seem a far too ambitious and challenging task, as it requires making
sense of an unlimited array of factors ranging from fundamentals
(macroeconomic changes, central bank actions, capital markets changes,
corporate/dealer transactions, political and geopolitical factors, and news
reports) to technicals (price charts, momentum, oscillators, moving averages) to pure ﬂow-driven developments
...
Since this book aims at focusing on the real-world
developments impacting currencies, textbook theories take a secondary
role in shedding light on the major developments in currencies
...
Chapter 3 and 4 tackle the trends in major
foreign exchange rates between 1999 and 2007, identifying the highest- and
lowest-performing currencies, and citing the fundamental reasons for these
developments
...
Performances are examined against a host of fundamental variables such as
national GDP growth, world and regional GDP growth, interest rates and
central bank action, capital ﬂows, current account balances, and export dynamics such as commodities markets
...

D

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CURRENCY TRADING AND INTERMARKET ANALYSIS

THE MAJOR THEORIES
As mentioned earlier, we will give a brief account of the major theories of
international economics seeking to explain foreign exchange market values, before tackling the practical underpinnings behind the performance
of each of the nine major currencies
...

Purchasing Power Parity
The theory of purchasing power parity (PPP) states that exchange rates are
determined by deriving relative prices of similar baskets of goods across
different currencies
...

The major advantage of PPP is that it provides for convenient and easy
comparisons when using similar products
...
In fact, PPP is only
valid for goods, not for services or in cases of signiﬁcant differences in values
...
There was little empirical evidence of the
effectiveness of PPP prior to the 1990s
...

Interest Rate Parity
The theory of interest rate parity (IRP) holds that a currency’s appreciation (depreciation) versus another currency in the future must be
neutralized by the interest rate differential
...
S
...
S
...
That
depreciation (appreciation) is reﬂected into the forward exchange rate
stated today
...
Its main weakness is the lack of proof
after the 1990s
...

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When the Dollar Was King (1999–2001)

53

Balance of Payments Model
The balance of payments model (BOP) maintains that a nation’s currency
must be at the rate that produces a stable current account balance
...
A nation with a trade deﬁcit experiences erosion in its foreign exchange reserves, and a subsequent decline
in its value
...

As in the case of purchasing power parity, the balance of payments
model addresses mainly tradable goods and services, while ignoring the
increasing role of global capital ﬂows
...
The increase in capital ﬂows has given
rise to the asset market model
...
The
emergence of cross-border capital ﬂows and trading of ﬁnancial assets has
reshaped the way markets approach currencies
...

Economic variables such as growth, inﬂation, and productivity are no
longer the only drivers of currency movements
...

ANNUAL PERFORMANCE ANALYSIS OF
INDIVIDUAL CURRENCIES
The following sections show the highest- and lowest-performing currencies
from 1999 to 2001, a period marked by general strength in the value of the
U
...
dollar
...
The following currencies are examined in this
analysis:

r U
...
dollar (USD)
r Euro (EUR)
r Japanese yen (JPY)

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r
r
r
r
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CURRENCY TRADING AND INTERMARKET ANALYSIS

British pound (GBP)
Swiss franc (CHF)
Canadian dollar (CAD), also known as the loonie
Australian dollar (AUD)
New Zealand dollar (NZD), also known as the kiwi

Currency returns are based on a yearly percentage return aggregating
each currency’s bilateral returns against all other seven currencies
...

1999: Risk Aversion, Bottom Fishing Boosts
Japanese Stocks and the Yen
The year 1999 witnessed the simultaneous recoveries of East Asian and
Russian economies following the market crisis of 1997–1998, and the continued boom into the equity markets of industrialized economies
...
The Japanese yen was the
highest-performing currency of 1999 as Japan offered the combination of
industrialized economy status and cheap valuation, as the country was
widely expected to ﬁnally recover from its decade-long economic slump
...
While the introduction of the euro to currency trading replaced the national currencies
of 11 European nations, U
...
equity markets were busy absorbing foreign
ﬂows chasing an increasingly solid bull market in high-growth technology
stocks
...
1
...
Meanwhile, the euro found no other way but down after the currency was inaugurated at an uncompetitive exchange rate against the dollar, yen, and pound, while devaluations of Asian currencies of 1997–1998
exacerbated Europe’s already lackluster exports foundation to the Far
East
...
But the euro
was not the worst performer in 1999
...
Figure 3
...

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55

When the Dollar Was King (1999–2001)

1999 Aggregate Currency Returns
150%
100%
50%
0%
–50%
–100%
–150%
JPY

AUD

CAD

USD

GBP

EUR

CHF

NZD

FIGURE 3
...

1999 Bilateral Currency Returns
AUDNZD
AUDCHF
CADCHF
GBPNZD
USDCHF
GBPCHF
AUDUSD
EURNZD
AUDCAD
EURCHF
GBPUSD
NZDCHF
AUDJPY
CADJPY
USDCAD
GBPCAD
EURAUD
GBPAUD
USDJPY
EURGBP
GBPJPY
EURUSD
NZDUSD
EURCAD
NZDCAD
CHFJPY
EURJPY
NZDJPY

–30
...
00% –10
...
00%

10
...
00%

30
...
00%

FIGURE 3
...

Japanese Yen: +99 percent The Japanese yen’s 1999 performance
was a resounding attack on conventional theories indicating that rising or
high interest rates boosted currencies, while low or falling interest rates
were negative for currencies
...
25 percent—already the lowest among

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CURRENCY TRADING AND INTERMARKET ANALYSIS

Japan's Bursting Stock Bubble
40000

Nikkei-225 Index

35000

30000

25000

20000

15000

10000
Jan-98

Jan-97

Jan-96

Jan-95

Jan-94

Jan-93

Jan-92

Jan-91

Jan-90

Jan-89

Jan-88

Jan-87

Jan-86

FIGURE 3
...

G7 economies—before being cut to 0
...
Instead, the yen was
boosted by a surge of global funds into Japanese stocks with the notion
that Japanese markets were set to gain the most from the global recovery
story, especially that Japan’s main equity index Nikkei-225 was drifting at
12-year lows in October 1998
...
Figure 3
...

Figure 3
...
9 trillion yen for the year in
net foreign purchases
...

Australian Dollar: +76 percent The Australian dollar was the
second-highest-performing currency in 1999, boosted by a 30 percent increase in copper prices as the world economy headed into recovery mode

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When the Dollar Was King (1999–2001)

57

Net Foreign Inflows into Japanese Stocks and Bonds
30
25
20

Billion Yen

15
10
5
0
–5
–10
–15
Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00

FIGURE 3
...

after the ﬁnancial turmoil of 1997–1998
...
As GDP growth in major industrialized economies
rose to 3
...
6 percent in 1998, the demand for copper
was robust and so was demand for Australian exports
...
4 percent GDP growth in 1999 was slower than the
5
...

Surging demand from newly industrialized economies (Hong Kong, Korea,
Singapore, and Taiwan) was also a boon for the aussie as these economies
posted an impressive 7
...
5 percent contraction in 1998
...
In 1999, energy products made up 11 percent of Canada’s
total exports, with crude oil accounting for 5 percent of exports
...
The loonie also gained more than 5 percent against the USD,
its best performance versus the greenback since 1988
...
5 percent from 4
...
1 percent average growth of 1989–1998
...

U
...
Dollar: +27 percent The combination of strong growth in the
industrialized world and fund managers’ risk aversion to nonindustrialized
economies rendered the quality and safety of U
...
stocks a fundamental
factor in going for U
...
markets, as was the case with Japan
...
S
...
5 billion in
1999, a 53 percent increase from the 1998 total
...
S
...
U
...
interest rates were raised back to 5
...
In fact, it was the ﬁrst time since 1984 that
U
...
rates had matched their UK counterpart after 15 years of underperformance
...

British Pound: +11 percent The British pound ended up gaining
only against EUR (12 percent), CHF (13 percent), and NZD (17 percent)
thanks to improved economic growth and a favorable interest rate environment as GDP growth remained at the 3 percent handle and the Bank of
England raised rates by 50 bps
...
But GBP lost ground against the JPY
(−12 percent), AUD (−9 percent), CAD (−8 percent), and USD (−2 percent) due to equity ﬂows, and commodity market developments prevailing
in Japan, Australia, and the United States
...
1740 in 1999, a
rate that turned out to be unsustainably high for the fundamentals of the
11-nation Eurozone
...

German and French exports had continued to struggle, especially with
11 percent of German exports sold to Asia
...
7 percent in 1997 to −0
...
6 percent in 1998 and 1999
...
7 percent in 1999, growth rates in Germany and Italy were subpar at 1
...
7 percent
...

The euro was also saddled by heightened uncertainty related to the
war in the former Yugoslavia, verbal clashes between Eurozone politicians,
and the ECB regarding the need for the central bank to cut interest rates
...

Swiss Franc: −95 percent The Swiss franc was the second-worst
performer in 1999 amid the eight major currencies due to a combination
of sluggish growth and cooling demand from the Eurozone
...
3 percent from 2
...
4 percent average of 1989–1998
...
Yet Switzerland lacked the size of Japan’s stock market capitalization, and thus was unable to absorb the magnitude of global
capital ﬂows that lifted Japanese stocks and the yen
...
Over 50 percent of New
Zealand’s exports came from agriculture, with dairy products accounting
for 20 percent of total exports
...
2 percent of GDP from 3
...
Food prices fell 12
...
The currency was also hit by falling poultry prices due to falling
Russian demand following the Russian currency crisis of 1998
...
S
...
S
...
(See Figure 3
...
) But despite strengthening global growth, metals
failed to sustain the solid performance of 1999 as paper currencies proved

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CURRENCY TRADING AND INTERMARKET ANALYSIS

2000 Aggregate Currency Returns
80%
60%
40%
20%
0%
–20%
–40%
–60%
–80%
USD

CHF

CAD

GBP

EUR

JPY

AUD

NZD

FIGURE 3
...
S
...

triumphant due to interest rate hikes throughout the industrialized world
...

To tackle rising inﬂation, the Federal Reserve raised rates by 100 bps
to a nine-year high of 6
...
75 percent respectively
...

The technology stocks bubble combined with accelerating growth
gave the USD its strongest showing among the eight currencies, while
exacerbating the lackluster performance in metals
...
The New Zealand dollar remained the worst performer for the
second consecutive year due to the nation’s high trade deﬁcit, while the
aussie was dragged down by a 3 percent decline in copper prices
...
(See Figure 3
...
)
U
...
Dollar: +61 percent Interest rate hikes, surging capital ﬂows,
strong growth, and rising inﬂation were all reasons for the dollar’s stellar
performance in 2000
...
9 billion in
1999, net foreign purchases of U
...
stocks rose 39 percent to a new record
of $174
...

But U
...
stocks weren’t the only destination of record foreign ﬂows
...
7 shows the breakdown of foreign ﬂows into U
...
assets between

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When the Dollar Was King (1999–2001)

2000 Bilateral Currency Returns
USDJPY
EURNZD
CHFJPY
GBPNZD
GBPAUD
CADJPY
EURJPY
USDCAD
GBPJPY
USDCHF
EURGBP
AUDNZD
CADCHF
EURCAD
GBPCAD
AUDJPY
EURAUD
EURCHF
NZDJPY
EURUSD
GBPCHF
GBPUSD
AUDCAD
NZDCAD
AUDCHF
NZDCHF
AUDUSD
NZDUSD

–20
...
0%

–10
...
0%

0
...
0%

10
...
0%

FIGURE 3
...
S
...

Net Foreign Flows Rose in Each U
...
Asset Class in 2000
300
Treasuries and Agency Bonds
Stocks
Corporate Bonds

250

USD Billions

200
150
100
50
0

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

–50

FIGURE 3
...
S
...

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CURRENCY TRADING AND INTERMARKET ANALYSIS

1989 and 2007, illustrating that 2000 was the only year with an increase in
net purchases of U
...
stocks, corporate bonds, Treasury securities (bills
and bonds), and agency bonds (bonds of local agencies and municipalities)
...
S
...
Such a remarkable trend in 2000 proved to be the
backbone of the dollar’s resulting 61 percent increase against AUD, CAD,
CHF, EUR, GBP, JPY, and NZD
...
S
...
Bush over Democrat candidate Al Gore was cheered by
U
...
markets due to market-friendly economic policies of the Republican Party
...
The dollar then rallied strongly during the recount period in midNovember with each subsequent news story rectifying the claim of a Gore
victory
...
But the highest GDP growth rate in over a decade
and a doubling of interest rates to 3
...
Swiss GDP growth
nearly tripled to 3
...
The growth story was
also bolstered by robust neighboring economies, such as the Eurozone and
the United Kingdom both growing by 3
...

But the franc’s gains were also related to risk appetite
...
What followed was a decline of 42 percent
and 18 percent in the NASDAQ and S&P 500, respectively, from September
to December 2000, which prompted currency traders to seek the safety of
the franc, as the Swiss economy remained sheltered from the slowing U
...

economy and bolstered by a growing European recovery
...
S
...
S
...

Canadian Dollar: +33 percent The Canadian dollar ranked thirdhighest returning currency for the second straight year, beneﬁting from a
combination of accelerating growth, rising interest rates, and a temporary

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jump in oil prices
...
The oil pullback
in late fourth quarter gave oil a modest 4 percent increase for the year,
but the $20 price spike between May and September 2000 was a boon for
the oil-dependent loonie
...
2
percent, following 5
...
1 percent average
of 1989–1998
...

British Pound: +3
...
5 percent cumulative return against the other seven major currencies shows that despite
the United Kingdom’s stellar GDP growth of 3
...
8 percent against EUR
...
Indeed, the
Bank of England joined the Fed in January 2001 to begin an extended easing campaign
...
2 percent The 175-point rate hikes from the ECB proved too
little too late in stemming the euro’s losing tide, whose intensiﬁcation began amid eroding credibility with ECB policy
...
While the ECB was
mandated to keep inﬂation below the 2 percent ceiling, inﬂation remained
below that ceiling throughout the year—despite rising from under 1
...
8 percent
...
Rather than boosting the currency, the rate hikes were
punishing the already struggling German and Italian economies
...
0 percent ceiling while money supply growth remained well above the ECB’s policy pillar of maintaining monetary growth
at an annual three-month average of 4
...

The bulk of the euro’s losses stemmed from an excessively restrictive
monetary policy and a central bank largely deemed to be inexperienced,
especially as differing points of view and statements from within the policy makers started to be more prominent
...
2

EURUSD

1
...
9

0
...
8 The euro’s intensifying sell-oﬀ of 2000 prompted the ECB to intervene with other major central banks on at least four occasions
...

In the last week of January 2000, the euro broke below parity with the
U
...
dollar, culminating a decline from its $1
...
EUR went on to lose 6 percent versus USD to reach an all-time low
of 82
...
S
...
There were four ofﬁcially reported interventions between September and November 2000, the last two of which took place one
day before and after the closely contested U
...
presidential election so as
to contain excessive dollar rally versus the euro
...
8
...
Just as Japanese stocks were among the ﬁrst to be snapped
up by global fund managers during the global economic recovery of 1999,
these were unloaded aggressively throughout 2000 as the global tech wreck
turned into an all-around global market corrosion
...
0 billion yen of Japanese stocks in 2000, following the record total
net purchases of 11
...

Australian Dollar: −49 percent The aussie’s underperformance of
2000 underlines the currency’s high correlation with copper prices, which

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65

overrides the impact of growth and interest rates
...
4 percent in 1999 to 3
...
3 percent
...
The aussie’s losses especially intensiﬁed when a robust
rally in the second quarter peaked in September at 16-year highs, before
starting a 12 percent decline into the rest of the year
...
Copper’s
decline in the fourth quarter emerged as slowing world growth was on the
cusp of recession
...
Although New Zealand’s current account deﬁcit stabilized from 6
...
1 percent in 2000, it remained the highest among developed nations, especially
as the global price environment for agriculture and dairy products turned
lackluster in the second half of the year
...
9 percent
from 4
...

2001: Recession Favors Dollar Due to
Aggressive Fed Cuts
The U
...
slowdown of the second half of 2000 intensiﬁed in 2001, causing
the economy to slip into recession, and dragging the rest of the world into
a standstill
...
S
...
As the U
...
imported
nearly a ﬁfth of the world’s exports, the proverbial U
...
sneeze left the rest
of the world with a cold
...
S
...
(See Figure 3
...
)
Since the downside risks to growth were markets’ top priority, traders
rewarded currencies whose central banks were boldest in cutting interest
...
0 percent in 2000 to 1
...
7 percent annual average of the prior decade
...
Figure 3
...

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2001 Aggregate Currency Returns
60%
40%
20%
0%
−20%
−40%
−60%
−80%

USD GBP CHF CAD NZD EUR AUD JPY

FIGURE 3
...
S
...

2001 Bilateral Currency Returns
USDJPY
GBPJPY
CHFJPY
EURJPY
CADJPY
NZDJPY
GBPAUD
USDCAD
AUDJPY
GBPNZD
GBPCAD
USDCHF
EURNZD
GBPCHF
NZDCAD
EURCAD
AUDNZD
EURCHF
EURGBP
GBPUSD
AUDCAD
CADCHF
NZDCHF
EURAUD
EURUSD
AUDCHF
NZDUSD
AUDUSD

−10
...
0%

0
...
0%

10
...
0%

20
...
10 U
...
dollar and Japanese yen were on opposite sides of the 2001
return spectrum
...
S
...
S
...
S
...
Two business days into the beginning of January 2001, the

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When the Dollar Was King (1999–2001)

Fed delivered an unscheduled 50 bps interest rate cut to start a 475-point
rate reduction campaign that took the Fed funds rate to a 45-year low of
1
...

Although the Fed funds rate dropped below the overnight rates of all
G7 nations with the exception of Japan, the U
...
dollar outperformed all
currencies in 2001
...
Such perception was also a result of the
fact that the easing campaign included two rate cuts during unscheduled
central bank meetings, highlighting the sense of urgency to stimulate the
economy back into growth
...
The dollar went on to rally by
3 percent in the fourth quarter in trade-weighted terms as fears inside the
United States were perceived to have been largely fended off when the
country took the offensive abroad to start the war against the Taliban in
Afghanistan
...
11
...
11 The Federal Reserve’s aggressive easing of 2001 boosted the dollar
because markets’ primary concern lay primarily with slowing economic growth
...
0 percent
...
8 percent in 2000 to 2
...
8 percent and 1
...
In fact, UK growth was highest among G7
nations in 2001
...

Swiss Franc: +23 percent At a time of escalating stock market volatility, subpar global economic growth, and weak commodity
prices—gold up only 2 percent and oil down 25 percent—the Swiss franc
was partially boosted by its role as a so-called safe currency
...
5 percent to 2
...
The currency also manifested
its ability to strengthen in times of geopolitical uncertainty, as was the case
during the September 11 attacks
...
1 percent against the dollar on the year
...
5 percent
...
S
...
Indeed, 90 percent of the $6 dollar decline in the price of oil for the
year took place after the September 11 attacks, on fears that the deteriorating recession would further weigh on oil demand
...
8 percent from the 5 percent handle of 1999–2000, the
currency fared well as FX traders rewarded the BoC’s proactive response
...

The Reserve Bank of New Zealand cut rates from 6
...
75 percent while GDP growth slowed to 2
...
9 percent
...
2 percent from 2
...
2 percent from 7
...
The year 2001 was a year of consolidation for the kiwi
after a 22 percent decline in the currency’s trade-weighted index during

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1999–2000
...

Euro: −6 percent The ECB took back all but one of the 2000 rate hikes,
slashing rates by 175 bps to 3
...
Despite ending the year in negative territory, EUR had a strong run between July and September, taking
advantage of a broad summer decline in the U
...
dollar as U
...
economic
data began to deteriorate
...

One noticeable pattern between EUR and USD developing in the ﬁrst
three years in the life of the young currency is the bipolarity between the
two pairs
...
This compared to a 13 percent share of trading volumes for USD/JPY and 12 percent for GBP/USD
...

We note later in the book the intensiﬁcation in the bipolarity of returns
between USD and EUR and touch upon its reasons and implications
...
The
global slowdown dragged G7 GDP growth to 1
...
The Reserve Bank of Australia’s
(RBA) 175 bps of rate cuts were the smallest among the eight currencies,
with the exception of the JPY, whose central bank cut rates by merely
10 bps
...
1 percent from 3
...

Japanese Yen: −69 percent While 2001 rewarded currencies whose
central banks delivered the most aggressive easing campaigns to tackle
the deteriorating growth climate, the already ultralow rate environment
in Japan meant the central bank was unable to deliver any further meaningful easing to stimulate the ailing economy
...
15 percent from 0
...
But the BoJ’s policy bind
was underlined in the real interest rate (nominal interest rates minus inﬂation), which was higher than the nominal rate because inﬂation stood below zero
...
Investors found no choice but to
sell the zero-yielding JPY, especially as Japanese stocks hit 15-year lows to
lose 24 percent for the year
...
As the world economy emerged from the Asian crisis of the late 1990s, U
...
markets provided
global investors with a winning combination of safety and growth
...
But 1999–2001 culminated in
the end of the dollar’s seven-year bull market
...

What followed next was the beginning of a protracted decline in the
U
...
currency along with a historic recovery in the euro and commodity
currencies, all of which are the subject of Chapter 4
...
S
...

The falling value of the dollar brought about a super rally in commodity prices, culminating in new record highs in precious metals, energy
fuels, and agricultural products
...
S
...
As in Chapter 3, the annual performance of
each currency is measured by aggregating a currency’s percentage changes
against each of the other seven currencies
...
S
...
U
...
manufacturers stepped up their complaints about an overvalued U
...
dollar eroding
their competitiveness, demanding that President Bush impose tariffs on
U
...
trading partners and declaring that the currency needed to depreciate
by about 40 percent
...
S
...

The dollar ceiling was ﬁrmly reached in spring 2002 when President Bush
launched a trade war, slapping foreign steel producers with tariffs in order to secure the Republican Party victory in key steel and manufacturing
states ahead of the Congressional elections later that year
...

As a result, selling the dollar across the board became the trade of
choice, especially amid the successful conversion of the euro into an obligatory currency of exchange in the Eurozone in 2002
...
S
...
(See Figure 4
...
)
Meanwhile, commodity prices rebounded due to the falling value of
the currency in which they were denominated, and partly due to a modest pickup in demand for energy and agriculture products
...
Interestingly, of the eight currencies under examination, only the central banks of commodity-based economies—
Australia, Canada, and New Zealand—raised their interest rates in 2002
...
2
...
1 U
...
dollar drops to bottom of currency returns in 2002
...
0% –15
...
0% –5
...
0%

5
...
0%

15
...
0%

25
...
0%

FIGURE 4
...

New Zealand Dollar: +97 percent
New Zealand’s dependence on agriculture exports was instrumental in the
kiwi’s recovery, which was made possible by a 3
...
5 percent and 0
...
Prices of agricultural raw materials moved from a
4
...
8 percent increase in 2002, surpassing the
1989–1998 average of −0
...
These price developments helped stabilize the country’s swelling trade deﬁcit, especially as neighboring Asian
economies’ growth rate rebounded to 5
...
2 percent in 2002
...
7 percent in 2001 to 5
...
1 percent
...
75 percent
...
(See Figure 4
...
)

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NZD Tracks Food and Agricutural Prices
15

5

10

0

5

−5

0

−10

–5
Food
Agri
NZD

−15
−20

97− 98

1999

2000

2001

2002

2003

NZD Index (Percent)

Food and Agricultural Prices (Percent)

10

–10

–15

FIGURE 4
...

Swiss Franc: +55 percent
The strong performance of the Swiss franc was largely a reﬂection of a
resurgence in European currencies exploiting the broad decline in the U
...

dollar, which set them off on a positive footing against other currencies
such as AUD and CAD, whereby the former was dragged down by weak
copper prices and the latter weighed down by the U
...
recession
...
S
...
The CHF gained only 1
...
8 percent and 8
...
The CHF gained versus
all of the currencies under examination with the exception of the kiwi
...
4 percent in 2002, the CHF
rally reﬂected a broad vote of conﬁdence in European currencies (EUR,
GBP, CHF), as these beneﬁted from the solid Asian recovery
...
S
...
S
...
The steel tariffs announced in March 2002 were also

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The Dollar Bear Awakens (2002–2007)

a green light to sell the dollar, as international trade actions are associated with nations increasing the competitiveness of their products abroad
...
The ECB allayed public concerns
of notes and coins shortages and worries about the spread of counterfeit
currency
...
Just as the euro suffered from the dollar’s solid performances in 2000–2001, it exploited the
dollar’s woes quite thoroughly
...
Figure 4
...

The main reason for the EUR-USD polarity is related to the growth
of trading volumes in the EUR/USD pair
...
S
...
4 The diverging paths of the dollar and the euro reﬂect the increased
duality between the two currencies
...
In 2004, trading in the EUR/USD pair accounted for 28
percent of all transactions, compared to 17 percent and 14 percent for
USD/JPY and GBP/USD
...

The euro’s dominance in the U
...
Dollar Index, a futures instrument
traded at the New York Board of Trade, also explains the polarity between
the two currencies
...
6
percent, followed by the JPY, GBP, CAD, the Swedish krona (SEK), and
CHF at 13
...
9 percent, 9
...
2 percent, and 3
...

The other reason for the EUR/USD polarity is the euro’s potential to
threaten the dollar’s role as the world’s reserve currency
...
S
...
In 2002, the euro’s share edged up to over 26
percent
...
S
...
Later in this chapter we consider how this
relationship is maintained during both positive and negative phases for the
two currencies
...

The year 2002 was the only year when the Bank of England made no change
in interest rates since the central bank gained independence in May 1997
...
GDP growth rate slowed further, reaching
2
...
4 percent in 2001
...
As then British Prime Minister Tony Blair stepped up his
support for a U
...
-led attack in Iraq, the UK position began to weigh on
sterling as the market punished currencies whose nations were pursuing
an increasingly isolated pro-war position
...
In November 2002, the
United Kingdom was the only G7 nation and permanent member of the UN
Security council supporting the United States in drafting a UN resolution
supporting war
...

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Consequently, sterling’s trade-weighted index (basked against selected
currencies) fell for seven consecutive months, between November 2002
and May 2003, the longest monthly losing streak since 1995
...
But the currency was unchanged against GBP as
the latter staged broad declines in the fourth quarter due to geopolitical
factors impacting the British pound
...
7 percent in 2001 to −0
...

Australian Dollar: −13 percent
The aussie gained only against the USD (10 percent) and CAD (9 percent)
in 2002, the two currencies whose economies were interconnected via the
sluggishness in the United States
...
The aussie’s negative
reaction to the late developments in copper was similar to that in 2000
when copper prices fell 12 percent in the third quarter, following an earlier
rally to 16-year highs
...

Canadian Dollar: −83 percent
Despite the 56 percent rise in oil prices and the Bank of Canada’s rate hikes
to 3 percent, the Canadian dollar fell against each of the said currencies
with the exception of the USD, against which it eked out a 1 percent gain
...
S
...
Indeed, exports fell 1
...
And although Canada voted against the Iraq war, once again
its proximity to the potential war-related economic downdrafts from the
United States was highly considered as a negative for the currency
...
5 percent
in 2001 to 2
...

U
...
Dollar: −91 percent
The aforementioned shift of currency policy by the Bush administration
toward that of a benign neglect (indirectly encouraging a dollar decline)
as well as the imposition of trade tariffs on foreign steel producers was a
green-light signal to sell the U
...
dollar regardless of fundamentals in other
economies
...
25 percent, while the broad
equity indexes tumbled to ﬁve-year lows on a combination of continued
fallout from overvalued valuations in technology and escalating news of
corporate malfeasances such as Enron, WorldCom, and Arthur Andersen
...
S
...
S
...
Prolonged interest rate cuts by the Federal Reserve to a 45-year low
of 1 percent also accelerated the dollar decline and boosted commodities
as the Fed vowed to inject the liquidity to allay the risk of deﬂation
...
” The Fed’s so-called reﬂationary monetary
policy—boosting liquidity to lift inﬂation above zero—was a signiﬁcant
negative for the U
...
dollar and a windfall for commodities as investors
ﬂed the low-yielding currency for the high-growth commodities as these
appreciated against their principal invoicing currency
...
The reaction to the unusual request was a
rapid decline in USD/JPY, which is explored later in this section under JPY
...
(See Figure 4
...
6
...

2003 Aggregate Currency Returns
150%
100%
50%
0%
–50%
–100%
–150%

AUD

NZD

CAD

EUR

GBP

CHF

JPY

USD

FIGURE 4
...

2003 Bilateral Currency Returns
AUDUSD
NZDUSD
AUDJPY
AUDCHF
EURUSD
NZDJPY
NZDCHF
GBPUSD
AUDCAD
CADJPY
CADCHF
EURJPY
EURGBP
EURCHF
AUDNZD
NZDCAD
CHFJPY
GBPJPY
GBPCHF
EURCAD
EURNZD
GBPCAD
USDJPY
USDCHF
EURAUD
GBPNZD
GBPAUD
USDCAD

–20
...
0%

0
...
0%

20
...
0%

40
...
6 AUD, NZD, and CAD occupy highest-performing FX pairs in 2003 due
to broad rally in commodities
...
8
Copper
AUDUSD

0
...
7
2500
0
...
6

1500
Oct-02

0
...
7 Copper prices are instrumental in aussie price action
...
1 percent in 2003 from
4
...
The resulting 45 percent increase in copper prices prompted currency traders to automatically bid up the aussie,
lifting it against all seven other currencies, while taking advantage of the
USD’s woes and dragging it down by 34 percent
...
7
...

r Fed cuts rates to 45-year lows
...

In trade-weighted terms, the aussie reached its highest since January
1989
...
7 percent and 5
...
8 percent and 3
...
The currency was hardly
fazed by 50 bps of rate cuts in the spring, as they were followed by a quarter point hike, taking the overnight rate to 5
...

Canadian Dollar: +32 percent
Tracking the rise in oil and decline in the U
...
dollar, CAD posted its biggest
percentage gain versus the U
...
currency, rallying 18 percent to 10-year
highs
...
Once U
...
and British troops took Baghdad in
April and President Bush announced “Mission accomplished” in early May,
oil prices fell back to as low as $25 per barrel amid fading risk premium in
the region
...
S
...
Although prices closed 2003 barely $1
above where they had opened the year, all signals pointed to further price
escalation, which boosted the oil-dependent Canadian dollar
...
Just as the euro had suffered from the dollar’s solid performances in 2000–2001, it now exploited the dollar’s woes quite thoroughly
...
2590, closing well above
the $1
...
The EUR-USD polarity
had already been seen in 1999–2000, but was magniﬁed in 2001 and beyond
as traders adopted an increasingly negative stance toward the U
...
dollar
...

In 2002, although Eurozone GDP growth slowed for the third consecutive year reaching 0
...
Speciﬁcally, the euro
appreciated 20 percent against the U
...
dollar, the highest annual increase
it attained against the major seven currencies over the 1999–2007 period
...
Looking at the performances of 1999, 2000, 2001,
2005, and 2006, EUR and GBP showed similar magnitudes in their returns
as these currencies were deemed economically interconnected
...
S
...
But the
relationship began to fade in the third quarter of 2002 when the United
Kingdom increasingly supported the tenuous U
...
cause to invade Iraq
...
8
...
Aside from the issues
of popularity and isolation, Britain subjected itself to the risk of terrorist
attacks by groups staunchly opposed to the war
...

Aside from geopolitics, the economic reasons for the sterling’s 2003
downfall included an unexpected interest rate cut in February, followed
by a subsequent cut in June to 3
...
The renewed easing from
the Bank of England punished GBP against major currencies, triggering a
decline even against the ultralow-yielding CHF
...

EUR Gains versus GBP as United Kingdom Joins Iraq War
0
...
7

0
...
6
1/6/2002

8/4/2002

3/2/2003

9/28/2003

FIGURE 4
...

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Swiss Franc: −38 percent
A combination of ultralow interest rates, falling domestic growth, and
weak external demand weighed on the Swiss currency against most major
currencies with the exception of the struggling GBP and low-yielding JPY
...
2 percent in 2003 after slowing in the prior
two years due to stalling demand from the sluggish Eurozone whose GDP
growth hit 0
...
9 percent and 1
...

Seeking to prevent geopolitically driven safe-haven ﬂows from boosting CHF excessively at a time when the world economy was already
dragged by higher oil prices, the Swiss National Bank eased monetary policy substantially
...
00–0
...
25 percent, driving away investors from
the ultralow-yielding currency
...
But the yen rallied as much as 10 percent
against the U
...
dollar for the year in reaction to one of the key developments dominating currency markets in 2003
...
The message was directed at China and Japan, which
were notorious for keeping their currencies artiﬁcially weak against the
´
U
...
dollar
...
70 to 113
...

U
...
Dollar: −127 percent
The year 2003 was the U
...
dollar’s worst year in terms of total returns
against the seven other major currencies, losing a cumulative 127 percent against AUD, CAD, CHF, GBP, EUR, JPY, and NZD by 34 percent,
18 percent, 10 percent, 11 percent, 20 percent, 10 percent, and 25 percent,
respectively
...
Markets clearly understood that Washington’s currency policy of benign neglect stemmed from its desire to see further decline in the

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dollar as long as it was orderly and did not erode general conﬁdence in U
...

assets
...
S
...
9)
...
S
...
Swelling U
...
trade
and budget deﬁcits combined with a currency policy of benign neglect accelerated the declines
...
1 percent in
2004, the highest growth rate since 1999
...
S
...

Currencies in general delivered their strongest performance against
gold since 1999 as central banks reached the end of their easing campaigns
and shifted to tighter monetary policies
...
Both the Federal Reserve
and the Bank of England began raising interest rates for the ﬁrst time in

2004 Aggregate Currency Returns

30%
20%
10%
0%
–10%
– 20%
–30%
–40%
–50%
–60%

NZD

CHF

EUR

CAD

GBP

JPY

AUD

USD

FIGURE 4
...

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The Dollar Bear Awakens (2002–2007)

2004 Bilateral Currency Returns
NZDUSD
EURUSD
GBPUSD
NZDJPY
CHFJPY
EURAUD
GBPAUD
AUDUSD
CADJPY
EURJPY
GBPJPY
NZDCAD
NZDCHF
EURGBP
EURCAD
GBPCAD
CADCHF
EURCHF
AUDJPY
GBPCHF
EURNZD
GBPNZD
AUDCAD
USDJPY
AUDCHF
AUDNZD
USDCAD
USDCHF
–10
...
0% –6
...
0% –2
...
0%

2
...
0%

6
...
0%

10
...
0%

FIGURE 4
...
S
...

three years, while the European Central Bank held rates unchanged after
cutting them in each of the previous three years
...
Figure 4
...

New Zealand Dollar: +26 percent
For the second year during this nine-year analysis period (1999–2007),
the NZD was the highest-ranking currency in terms of cumulative returns
...

The RBNZ raised rates on ﬁve occasions, boosting the cash rate to
6
...
3 percent from 1
...
4 percent from 3
...
As long as the
growth and inﬂation arguments were in place for aggressive rate hikes,

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investors were willing to chase the higher-yielding kiwi as a carry-trade
investment
...
Consequently, investors reap the beneﬁt of the interest rate differential as well as the appreciation of the target currency
...

Rising commodities was another factor behind the soaring kiwi
...
5 percent in 2004 after 6
...
7 percent in 2003 and 2002, respectively
...
3 percent
after 5
...
4 percent, while prices for agricultural raw materials increased 5
...
7 percent and 1
...
With over
50 percent of New Zealand’s exports coming out of the agriculture sector, and with dairy products accounting for 20 percent of total exports, the
continued price growth was a clear windfall for the nation’s GDP growth
and currency
...
4 percent GDP
growth rate after 3
...

Swiss Franc: +19 percent
Though not spectacular, the cumulative returns of the Swiss franc were
sufﬁcient to place it in second position in the 2004 ranking due to a robust export-led recovery following the 2003 recession
...
5 percent from −0
...
0 percent from 0
...
3 percent from 2
...
Battling the risk of deﬂation, the
Swiss National Bank held rates unchanged, which increased demand for
currency deemed to have been undervalued, relative to the nation’s GDP
growth rate
...
Gaining from a jump in GDP growth to
2
...
8 percent in 2003, and from the absence of ECB policy tightening, the euro accumulated a strong boost of conﬁdence in its
sixth year of operation
...
Trichet also became the single dominant voice of the euro, unlike in
the early years when several policy makers tended to give misleading and
inconsistent signals
...
S
...
EUR maintained its role of the
anti-dollar in global currency markets as the EUR/USD pair accounted for
28 percent of all transactions, compared to 17 percent and 14 percent for
the USD/JPY and GBP/USD pairs
...
30 mark
for the ﬁrst time in history, delivering a resounding signal of conﬁdence to
currency traders and global asset managers
...
Exports rose 7
...
4 percent
and 1
...
The role of rising oil prices
was highlighted in the fact that energy exports accounted for 16 percent of
total exports in 2004, following 15 percent and 12 percent in the prior two
years
...
Beneﬁting from the impact of higher oil and a sharp recovery in
GDP growth to four-year highs at 3
...
S
...
Those returns placed the CAD on the radar screen of asset managers seeking returns from a nation with budget and trade surpluses—the
antithesis of the U
...
economy
...
The Bank of
England’s ﬁve rate hikes between November 2003 and August 2004 had
started to take effect in summer 2004
...
6 percent, posting its 10th monthly decline in the
preceding ﬁve years, a period when home prices had more than doubled
...
2 percent and
0
...
(See Figure 4
...
)

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GBP Dragged by Slowing House Price Growth

102

20%

100

15%

98

10%

96

Home Prices
GBP Index

5%

94

92

0%
Jan-03

GBP Index

104

25%

Home Price Growth

30%

Jul-03

Jan-04

Jul-04

Jan-05

Jul-05

FIGURE 4
...

In addition to the housing slowdown, central bank policy makers had
begun signaling the peak in interest rates, thus accelerating the declines in
the currency
...
The decline against the NZD was
based on surging carry trade, whereby investors funded investments in
low-yielding JPY (0
...

So why did the JPY fall by the same amount against the USD when U
...

interest rates stood at the relatively low levels of 1
...
S
...
A lower yen also helped Japan ﬁght its deﬂation problem as negative price growth entered its sixth consecutive year
...
Unlike the 2003 interventions, which

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were carried out almost every month, the yen-selling interventions of 2004
lasted only the ﬁrst four months of the year, albeit on a greater scale
...
Despite a 46 percent increase in copper prices and an
increase in GDP growth from 3
...
1 percent, many home
buyers were forced to let their properties go into foreclosure, thereby impacting consumer expenditure
...
The peak was reached in mid-2003
...
8 percent to 2
...
The interest rate hikes of November and December 2003 helped accelerate the slowdown into the ﬁrst half of 2004, and caused the central
bank to refrain from raising rates for the ﬁrst time since 1999, when the
economy struggled following the 1997–1998 Asian crisis
...
25 percent throughout the year, speculation of an RBA rate cut was behind the aussie’s declines
...

U
...
Dollar: −48 percent
Despite 10 rate hikes of 25 bps each by the Federal Reserve, the U
...
dollar
ended at the bottom of the performance rank for the third straight year in
2004
...
55 billion in ﬁscal 2004
following a record $377
...
The ﬁscal proﬂigacy of
the Bush administration and its negative impact on market sentiment was
largely the cause of the renewed attack on the currency after his reelection
in the 2004 elections
...
The U
...
trade gap hit a record 5
...
Despite the 30 percent drop in the
dollar’s trade-weighted value since January 2002, the U
...
trade gap had
risen by over 80 percent
...
S
...
The currency policy of benign neglect also hurt the greenback
...
S
...
It wasn’t until 2005 that prolonged Fed tightening would
begin helping the U
...
currency
...
S
...
There were
several reasons for these developments:

r Continued Fed rate hikes into 2005 lifted U
...
rates back above their
Canadian, Eurozone, and UK counterparts, offering USD holders a
more favorable interest rate differential
...
S
...

r Soaring demand for commodities was ampliﬁed by China’s advance as
the world’s top consumer of most agricultural and metal products
...

Figure 4
...
S
...

2005 Aggregate Currency Returns
100%
80%
60%
40%
20%
0%
−20%
−40%
−60%
−80%

CAD

USD

NZD

AUD

GBP

EUR

CHF

JPY

FIGURE 4
...
S
...

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The Dollar Bear Awakens (2002–2007)

This was also the year of carry trades as global investors beneﬁted
from diverging monetary policies between the low interest rate currencies
of Japan and Switzerland, and higher interest rate currencies of the United
States, Canada, Australia, and New Zealand
...
As these ﬂows were mobilized, the higher-yielding currencies outperformed, while lower-yielding currencies headed down across the board
(see Figure 4
...

Canadian Dollar: +88 percent
The Canadian dollar attained a cumulative 88 percent increase against the
seven major currencies in 2005, its highest return during 1999
...
The combination of an external-led expansion and strong
domestic demand fed into rising inﬂation, which reached 2
...
8 percent, driving the Bank of Canada to raise rates by 75 bps to a twoyear high of 3
...

2005 Bilateral Currency Returns
CADJPY
CADCHF
USDJPY
USDCHF
NZDJPY
NZDCHF
AUDJPY
AUDCHF
GBPJPY
GBPCHF
EURJPY
EURCHF
CHFJPY
AUDNZD
EURGBP
USDCAD
GBPAUD
NZDUSD
GBPNZD
AUDUSD
EURAUD
NZDCAD
EURNZD
AUDCAD
GBPUSD
EURUSD
GBPCAD
EURCAD
–20
...
0% –10
...
0%

0
...
0%

10
...
0% 20
...
0%

FIGURE 4
...

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Although Canadian interest rates were lower than in the United States,
United Kingdom, Australia, and New Zealand, the CAD delivered the better
performance against those currencies due to its beneﬁting from rising oil
...
S
...
It also delivered solid gains versus CHF, JPY, EUR,
and GBP at 19 percent, 19 percent, 15 percent, and 13 percent respectively
...
S
...
S
...
After slashing rates to a 45-year low at 1 percent in 2003, the
Federal Reserve began a gradual policy of normalizing monetary policy in
2004 and 2005, with ﬁve and eight 25 bps rate hikes respectively, taking
the Fed funds rate to 4
...
The incremental
tightening served to contain inﬂationary pressures without hampering the
economic recovery from the 2000–2001 recession as the Bush $212 billion
tax stimulus worked its way through the economy
...
S
...

The dollar also beneﬁted from the Homeland Investment Act, which
was part of the American Jobs Creation Act of 2004, signed into law by
President Bush, allowing U
...
companies to repatriate earnings permanently reinvested abroad
...
25 percent, rather than
the normal tax rate of 35 percent, prompting companies to bring back an
estimated total of $180 to $210 billion
...

New Zealand Dollar: +23 percent
The kiwi maintained its strong positive correlation with rising food and
agricultural raw materials, while gaining from a rising interest rate environment as the central bank tightened rates by 75 bps to 7
...
As central banks raised rates in concert, investors sought added returns in growth
and yield, which was on offer by the kiwi
...
9 percent to 4
...
Offering the highest interest rates among the eight currencies, the kiwi was a popular destination

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for carry trades, appreciating 10 percent against JPY and CHF
...
S
...

Australian Dollar: +11 percent
The aussie managed to stand out as a net gainer in 2005 as the Australian
economy struggled to recover from the housing correction
...
7 percent in 2004 to 2
...
And despite slowing GDP growth in Australia
and the NIAEs, the bulk of the aussie’s gains were a result of broadening
carry trades as the RBA raised rates to 5
...
The central bank kept
the door open for further tightening as inﬂation rose to 2
...
3 percent
...
The slowdown of 2004 grew
more pronounced in 2005, and annual home price growth hit its lowest in
nine years, while month-to-month rates were showing declines
...
Sterling’s worst performances were against the
CAD and USD and −13 percent and −10 percent respectively
...
Eurozone France’s rejection of a proposed
European Union Constitution dealt a blow to conﬁdence in the European
Union and the future of its currency, especially with France being the
second-largest economy of the Eurozone
...
The slowdown in Eurozone GDP
growth to 1
...
0 percent as well as that in the United Kingdom and Switzerland also weighed on the region’s net external trade
...
The euro’s dominance in the U
...
Dollar
Index caused the polarity between the two currencies
...
6 percent, followed by the JPY, GBP, CAD,
SEK, and CHF at 13
...
9 percent, 9
...
2 percent, and
3
...
As the dollar rallied strongly against most currencies, the euro took the short end of the stick
...
The Swiss franc’s woes were magniﬁed by the fact that the Swiss
National Bank had kept rates unchanged around their 0
...
As global growth picked up and equity indexes recovered to ﬁve-year highs, investors developed higher risk
appetites, using low-yielding currencies as funding vehicles
...
The 57 percent cumulative decline against the group of
seven currencies was the second biggest in this 1999–2007 period as investors borrowed in ultralow Japanese interest rates to ﬁnance higheryielding investments
...
14)
...
S
...
No longer obtaining a boost from Fed rate hikes
and repatriation ﬂows, the U
...
dollar gave back most of its 2005 gains to
end among the big losers in 2006
...
15
...
14 Higher global interest rate* drove down JPY as investors sold the
low-yielding currency and placed proceeds in higher-yielding currencies and investments
...

2006 Aggregate Currency Returns
80%
60%
40%
20%
0%
–20%
–40%
–60%

GBP

EUR

AUD

CHF

NZD

USD

CAD

JPY

FIGURE 4
...

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The British pound made an aggressive comeback from its sluggish
2003–2005 performances as the Bank of England delivered two surprising
rate hikes in the second half of the year aimed at containing rapid credit
growth and house price appreciation
...

Gold’s retreat was a result of midyear nervousness with emerging markets
and fears that high interest rates in Japan would reduce global liquidity and
weigh on risk appetite
...
(See Figure 4
...
)

British Pound: +66 percent
The sterling delivered its strongest annual cumulative performance against
the seven major currencies in 2006, its best showing during the 1999–2007
period
...
16 percent, its highest level
since 1999
...
While the Federal Reserve, European
Central Bank, Bank of Canada, Reserve Bank of Australia, and Reserve
2006 Bilateral Currency Returns
GBPJPY
GBPCAD
GBPUSD
EURJPY
EURCAD
EURUSD
GBPNZD
CHFJPY
AUDJPY
AUDCAD
AUDUSD
EURNZD
GBPCHF
GBPAUD
AUDNZD
NZDJPY
NZDCAD
EURCHF
NZDUSD
EURAUD
USDJPY
CADJPY
USDCAD
AUDCHF
EURGBP
NZDCHF
USDCHF
CADCHF

–10
...
0%

0
...
0%

10
...
0%

20
...
16 The British pound was the highest-performing currency of 2006
while the euro followed closely behind
...
It wasn’t until August
2006 that the BoE began raising rates as inﬂation exceeded the 2
...
With UK
interest rates already at a relatively high 4
...
A surprise BoE rate hike on August 3 extended sterling’s gains across the board, and hawkish inﬂation reports from the BoE
in August and November conﬁrmed that further increases were in store for
2007
...

In December 2006, sterling broke above $1
...
S
...
The new landmark provided a
particularly tremendous boost of conﬁdence for the currency, as the landmark signaled the shifting of billions of U
...
dollars among asset managers
in asset allocation plays, and among central banks considering rebalancing
their reserves into higher-yielding currencies
...
S
...
S
...
On the monetary policy front, the ECB
delivered well-telegraphed rate increases with the aim of normalizing
policy— after slashing rates aggressively in 2001–2003 and containing inﬂation without endangering growth
...
Such is the
trademark of central bank credibility
...

On the U
...
front, persistent declines in housing prices and falling construction spending were showing nascent signs of extending to the rest of
the economy, forcing the Federal Reserve to end its two-year tightening
campaign after 17 rate hikes
...
S
...
25 percent in June 2006, Eurozone interest rates rose to 3
...
S
...
25 percent in January from 3
...
With Eurozone GDP growth continuing to grow faster than its U
...

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Euro Regains Key $1
...
36

EUR/USD

1
...
26

1
...
16
11/6/2006

8/14/2006

5/22/2006

2/27/2006

12/5/2005

9/12/2005

6/20/2005

3/28/2005

1/3/2005

FIGURE 4
...
30 level in
October 2006 on reports that German growth would surpass that of the United States
...
S
...

The euro also beneﬁted from increased speculation that global central banks would reduce their buildup of USD-denominated currency reserves in favor of the euro
...
17
...
Central banks from Arab Gulf
nations made several statements signaling their willingness to diversify
reserves into non-USD currencies and gold
...
Although such pronouncements meant that central banks would slow their future accumulation of U
...
dollars, rather than dump their U
...
reserves, they triggered
various bouts of selling in the greenback
...
An emerging drought pushed up prices of wheat by over 50 percent, boosting

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revenues of Australia’s biggest-selling crop
...
Copper prices rose
as much as 75 percent in the ﬁrst half of the year but lost a third of their
gains into the second half
...
The resulting increase in inﬂation from 2
...
5 percent was above the preferred range of the central bank, forcing
interest rates to rise by 75 bps to a 10-year high of 6
...

Swiss Franc: +19 percent
A sharp increase in Swiss GDP growth and the largest interest rate increase
in decades gave the Swiss franc the best cumulative return among the eight
major currencies under review
...
75 percent over
the next two years
...
0 percent, as GDP growth jumped to a six-year high of 3
...
4 percent
...
The unwinding of carry trades shifted capital back to the
lower-yielding franc
...
0 percent
...

New Zealand Dollar: −16 percent
It was a tale of two halves for the kiwi as the currency tumbled 11 percent
in trade-weighted terms in the ﬁrst six months, before regaining 90 percent of those losses in the second half of the year
...
There were three main reasons for
the kiwi’s 2006 performance:
1
...
Finance Minister Cullen went as far as taking the unorthodox

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step of warning speculators of a currency loss of as high as 40 cents
amid dimming prospects of further rate hikes
...
The unwinding of carry trades away from high-yielding currency was

accelerated late in the second quarter as global equity markets tumbled
by 7 to 8 percent from their ﬁrst-quarter highs
...
The Reserve Bank of New Zealand held rates unchanged at 7
...
It was the ﬁrst time in ﬁve years that rates were not hiked
by the central bank
...
6 percent from 2
...

U
...
Dollar: −43 percent
The much-anticipated end of the Federal Reserve’s two-year campaign
took place in summer 2006, prompting currency markets to begin paring
their dollar longs
...
One year after peaking
out, the U
...
housing market was signaling increasingly consistent signs
of weakness, from falling home prices to sluggish construction spending
and falling housing starts and permits
...
S
...
Although the Federal Reserve persisted in signaling its preoccupation with rising inﬂation, markets were beginning to perceive the Fed’s concerns as largely tactical rhetoric aimed at
supporting the U
...
dollar and bond yields without following through with
an actual rate hike
...
S
...
S
...
This was conﬁrmed across the board
as the Bank of England, Bank of Japan, European Central Bank, Swiss
National Bank, and Reserve Bank of Australia continued raising rates in
the second half of the year, a situation of contrasting monetary policies not
seen in over a decade
...
S
...
30
and extending it by 11 percent for the year
...
Oil reached a record $77 per barrel in August 2006, posting a 26
percent increase on the year before losing all of those gains in the fourth
quarter
...
The currency had climbed 7 percent against the U
...
dollar to hit 28-year highs at
$1
...

The subsequent sell-off in CAD was exacerbated in October when
Canada’s government announced a new tax on income trusts, whose
exemption had enabled domestic and foreign companies to avoid paying
hundred of millions of dollars in taxes each year
...

The consequences were equally negative for the CAD, which lost more than
5 percent in the fourth quarter alone
...

Japanese Yen: −51 percent
The Japanese yen lost a cumulative 51 percent against the other seven major currencies in 2006, to fall into the bottom rank of returns for the second consecutive year
...

One reason for that is the highly defensive rhetoric communicated by
Japanese policy makers in signaling the much-anticipated rate hike
...

As the Bank of Japan prepared to raise rates from their ultralow levels of
0
...
A rate hike would have accelerated the yen’s appreciation,
thereby possibly throwing the economy back into deﬂation mode
...
Failure to raise rates would have prolonged carry trades’ negative impact on the yen and discouraged global
capital ﬂows away from yen-denominated assets
...
By the time the rate hike took place in July 2006,
equity markets had stabilized and global investors gradually shifted to lowyielding currencies to fund a renewed run-up in high-yielding currencies,
equities, gold, and oil
...
The currency developments of
2007 were largely dominated by two main themes:
1
...

2
...
(See Figure 4
...
)
The Japanese yen amassed broad gains during periodic episodes of
risk appetite reduction as global stocks sold off aggressively in the midst
of subprime-related losses in the U
...
ﬁnancial sector
...
The commodity currencies of CAD,
AUD, and NZD were boosted by new record highs in prices of energy, metals, and agriculture as well as high interest rate policies
...
S
...
While the three commodity currencies
2007 Aggregate Currency Returns
80%
60%
40%
20%
0%
–20%
–40%
–60%

CAD

AUD

EUR

NZD

CHF

JPY

GBP

USD

FIGURE 4
...

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The Dollar Bear Awakens (2002–2007)

2007 Bilateral Currency Returns
CADJPY
AUDUSD
CADCHF
EURUSD
NZDUSD
EURGBP
AUDJPY
EURJPY
AUDCHF
NZDJPY
EURCHF
NZDCHF
AUDNZD
GBPUSD
EURNZD
CHFJPY
EURAUD
GBPJPY
EURCAD
GBPCHF
USDJPY
USDCHF
NZDCAD
AUDCAD
GBPNZD
GBPAUD
GBPCAD
USDCAD

–15
...
0%

–5
...
0%

5
...
0%

15
...
19 The euro’s presence among the commodity currencies in the top
performers of 2007 reﬂects its broadening strength
...
(See
Figure 4
...
)

Canadian Dollar: +62 percent
Record levels in oil prices gave the Canadian dollar a cumulative 61 percent return against the seven major currencies, as energy exports made up
over 20 percent of total exports and 10 percent of GDP
...
Especially favorable for the CAD were continued signs of expansion in Canada’s economy despite the sharp slowdown south of the border
...
8 percent,
while GDP growth rate cooled to 2
...
8 percent
...
5 percent
...

Australian Dollar: +22 percent
The aussie surged against the USD, GBP, and EUR to the highest levels in
23 years, 10 years, and 7 years, respectively, as interest rates hit 11-year
highs at 6
...
4 percent
...
3
percent offered high real interest rates (nominal rates less inﬂation), an attractive combination to investors
...
Prices of wheat
doubled for the year to hit a record high of $10 per bushel, while copper
prices rose 30 percent due to surging demand from China
...
2 percent and GDP growth
at decade highs, traders found proof of a surging economy in the face of
protracted currency strength, thereby further bidding up the currency to
multidecade highs
...
(See Figure 4
...
) Between November and
December 2007, the aussie’s trade-weighted index lost 7 percent as global
equities fell across the board on write-downs from struggling U
...
banks
...

Yen Crosses Guided by Carry Trades
110

170
EUR/JPY

105

AUD/JPY

160

100

155

95

150

AUD/JPY

EUR/JPY

165

90

145
1/7/2007

85
5/27/2007

10/14/2007

3/2/2008

FIGURE 4
...

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The Dollar Bear Awakens (2002–2007)

Euro: +21 percent
The strength of the euro’s 2007 performance was particularly highlighted
by the contrasting growth and interest rate climates between the Eurozone
and the United States, as the former grew at a rate of 2
...
9 percent for the latter
...
25
percent, taking down the U
...
rate advantage to a three-year low
...
S
...

(See Figure 4
...
)
Unlike in previous years of EUR strength and USD weakness when
the euro largely beneﬁted from USD weakness, the 2007 dynamics were a
result of eroding USD fundamentals as well as cyclical Eurozone strength
...
Having said that, the single currency continued to
play the role of the antidollar, helping to bolster its upward run to record
highs versus the USD, GBP, JPY, and CHF
...
50

1
...
00

1
...
50

1
...
4

–0
...
3

–1
...
2

–1
...
00

1
...
00
–2
...
00

0
...
50

0
...
21 Widening interest rate diﬀerentials between German and United
States 10-year bond yields left little choice for currency traders but to send EUR/USD
higher
...
Speculative interest also played a vital role in sustaining
the kiwi’s gains, especially from traders who funded their investments
with low-yielding currencies such as the yen
...
25
percent, the highest level since its introduction in 1999
...
3 percent and 3
...
Currency strength
lifted the kiwi to 25-year highs against the U
...
dollar, prompting the central
bank to intervene by selling kiwis in the open market to stabilize the trend
...
The RBNZ gave up intervening after three failed attempts and the kiwi pursued its run-up to multidecade highs
...
GDP growth hit a three-year high of 2
...
4 percent
...

Swiss Franc: −10 percent
The low-yielding Swiss franc served its role of a funding currency to carry
trades targeting higher-yielding currencies and growth alternatives such
as stock indexes, individual stocks, oil, and gold
...
Conversely, the franc rallied signiﬁcantly as those trades were unwound during periods of rising
volatility
...
2 percent, 6
...
7 percent
respectively, while the Swiss franc rallied against the USD and AUD by
0
...
9 percent, 1
...
0 percent, 3
...
4 percent respectively
...
Once the summer market turmoil deteriorated into the rest of the
year, JPY rebounded 4 percent, ending down 0
...
The

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currency was characterized by several episodes of extremely rapid gains,
gaining more than 4 percent or 500 points in a single day (August 16)
...
5 percent, worrying that slowing U
...
growth would drag down Japan’s
economy and a rate hike would risk jeopardizing the fragile recovery
...
S
...
Despite having breached the $2
...
The currency closed at
all-time lows against the euro to lose 8
...

After a strong seven months, sterling’s fundamentals began to deteriorate due to prolonged declines in housing prices, a struggling banking
sector suffering from dried-up liquidity, and a near collapse of the nation’s
biggest mortgage lender, as well as eroding conﬁdence among households
and businesses
...
House price indexes began showing three consecutive monthly declines, a pattern not seen in over 12 years
...
Estimates placed the number of
homes to be repossessed in 2007 at 30,000 to 45,000 in 2008, the highest
since the property crisis of the 1990s
...

UK interest rates were raised three times, reaching a six-year high of
5
...
But as the cracks began to show, the Bank of England was
obliged to cut rates by 25 bps in December, earlier than it anticipated in
the November inﬂation report
...
The Bank of England
had already been forced into a unanimous decision to cut rates in December, one month earlier than it predicted at the November inﬂation report
...
50 percent, which would deal sharp erosion to real interest rates, currently at 3
...

U
...
Dollar: −51 percent
The dollar’s trade-weighted index dropped 9 percent to 74
...
The speed of the 2007 dollar decline was particularly intensiﬁed by two factors: (1) the speed at which the

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Federal Reserve shifted its policy emphasis from worrying about
inﬂation—in August—to making an about-turn and slashing interest rates
within less than four weeks; (2) the continued divergence in growth and interest rates between the United States and the rest of the G7, to the extent
of driving the Federal Reserve to cut interest rates, while the ECB, United
Kingdom, Canada, and Australia were raising interest rates
...
S
...
S
...

One other factor behind the falling value of the dollar is that of reserve
diversiﬁcation away from U
...
dollars among global central banks and
private asset managers
...
7 trillion in currency reserves from over 90 percent
USD-denominated in 2000 to less than 70 percent in 2005
...
Although
such pronouncements meant that central banks would slow their future
accumulation of U
...
dollars, rather than dump their U
...
reserves, they
triggered various bouts of dollar selling and worsening sentiment for the
currency
...
S
...
With the
dollar having lost over 30 percent of its value in trade-weighted terms over
the previous ﬁve years, the currency’s decline sent inﬂation soaring in the
Gulf countries, prompting Kuwait to break from its dollar peg in early 2007
and to revalue its currency twice after inﬂation hit an all-time high of 14
...
Speculation abounded that the UAE, another country
maintaining its dollar peg, may either revalue its currency to a new peg or
break off the currency system altogether after inﬂation reached a 19-year
high of 9
...
In early January, ofﬁcials from Saudi Arabia and the
UAE said they would continue pegging their currencies to the U
...
dollar
and no revaluation will take place
...

LESSONS LEARNED
Several lessons can be learned from the currency developments of 1999–
2007
...
As the two currencies dominated trading in global foreign exchange markets, one currency would
persistently act as an opposite for the other
...
However, trading in the currency pair
increased 42 percent to $501 billion between 2001 and 2004, before leaping
67 percent to $840 billion from 2004 to 2007
...
Consequently, foreign exchange markets became segmented into a new set of currencies, against
which low-yielding currencies were the ﬁrst to drop during any signs of improved global growth such as strong economic data from the United States
or China, or any signs of reduced risk appetite
...
The combination of the widening gulf between low- and high-yielding
currencies, and the reduction of fear—as gauged via falling volatility and
rising global equities—had triggered a nearly systematic shift into higheryielding currencies at the expense of the low-yielding CHF, JPY, and the
USD
...
Conversely, JPY is the main winner out of these three currencies
during rising volatility and falling equities
...
Other important factors such as global growth, risk aversion,
carry trade unwinding, and the direct relationship between commodities
and their currencies have had signiﬁcant weight
...

Capital ﬂows are another reason why interest rate differentials may
not work in driving currencies
...
Escalating anticipation of an eventual Japanese recovery following the slump of
the 1990s drove asset managers to snap up Japanese stocks, which were
largely deemed to be undervalued
...
In such cases where the interest

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rate landscape is largely unchanged, other dynamics succeed in taking over
the inﬂuence over foreign exchange values
...
The reverse relation took place in 1998–1999 when regional trade was hampered by the
1997–1999 Asian crises
...
The powerful advance in China’s
GDP growth between 2004 and 2005 proved a vital source of demand for
Australia’s iron ore industry, thus alleviating the fallout from the burst of
Australia’s real estate bubble
...
The extent of the relationship is also underlined by not only whether copper has ended higher or
lower at year-end but also by the metal’s most recent performance shift
during the year
...

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CHAPTER 5

Risk Appetite
in the Markets

anaging risk has become an increasingly integral part of the
risk/return trade-off in ﬁnancial markets over the years as participants seek to improve the proﬁtability of their investments while
attempting to reduce their downside
...

The latter type of investment risk is most relevant to this chapter as
it involves risk appetite in the way funds are raised and where they are
invested
...
Yet, regardless
of the likelihood of recouping one’s initial investment, the principal idea is
underlined by the notion of minimizing the use of one’s own funds with the
hope of maximizing the rate of return
...
Let’s say Jane purchases 200 shares of a pharmaceutical
company priced at $50 each with the intention of selling them in two weeks
based on her expectation of a favorable ruling by the Federal Drug Administration
...
Assuming the

M

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FDA rejects the introduction of a new drug by the company and the stock
price plummets to $15 per share after one year, Jane’s holdings would drop
to $3,000
...
Had she borrowed the funds at 7 percent, Jane would
be obligated to return the initial $10,000 loan plus the interest rate cost of
$722
...
90
...
90 on an investment that fell to $3,000 entails a loss of 357 percent, versus a loss of 40 percent in the case of the
no-loan option
...
Under the same
price increase scenario, Jane’s 7 percent loan would have an interest cost
of $722
...
10 or a 1,837 percent rate of return
...
Conversely, the loan would have magniﬁed her loss
to a 357 percent loss compared to 40 percent using her own money
...
But for the sake of relevance to this chapter, I focus on the environmental factors impacting her tolerance for risk
...
None of these dynamics are related to the company per se, but they do shape the general climate impacting the share price
...
Thus, even if there is no improvement in the company’s speciﬁc fundamentals, Jane’s risk appetite may be
driven by a generally positive environment, conducive to raising risk appetite and conﬁdence, sometimes at the expense of overlooking some vital
elements pertinent to the individual stock
...

CARRY TRADES IN FOREIGN EXCHANGE
Borrowing money at low interest rates to fund higher-yielding loans has
been the conventional source of revenue for banks for as long as credit

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providers have been around
...
An extra return can be obtained during the appreciation of the
high-yielding currency, while in other cases the currency depreciation is
greater than the interest rate differential, making the carry trade a losing
investment
...

Carry trades are also used in bond investing within the same currency
by borrowing (selling) bonds at short-term interest rates to ﬁnance the
purchase of long-term bonds at higher rates
...
The downside risk
entails an unexpected decline in the price of long-term bonds (and rising
long-term interest rates), and a rise in the price of short-term bonds (falling
short-term rates)
...
e
...

Let’s return to carry trades in currencies
...
70 percent interest and deposits
the proceeds in a U
...
dollar–denominated 10-year government bond worth
$1,000, paying 5 percent interest
...
3 percent
from the interest differential plus or minus the exchange rate risk
...
S
...
3 percent (4
...
If the dollar loses 5 percent against the yen, the investment
nets a loss of 1
...
3 percent yield differential minus 5 percent
currency loss)
...
While higher interest rate differentials play a major role in spurring interest in carry trades, the potential for currency appreciation or depreciation is also essential in sustaining the viability of
the trade
...
As these players
aim at reaping the gains from the interest rate differential, they tend to
leverage their positions to magnify their returns from what appears to be
an assured investment
...
3 trillion in daily turnover,

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currency markets thrive on trading volumes among bank dealers, corporate treasuries, and speculators
...
The result could entail prolonged trends lasting for several weeks
and months
...
Carry trades are
notably visible once they start to unwind
...
Such unwinding takes place upon the
following:

r Anticipation of a decline in the high-yielding currency or an actual decline in its value
...

r Anticipation of a decrease in interest rates of the high-yielding currency, or the end of its tightening cycle
...

r A sudden decrease in risk appetite, which normally leads to a decrease
in the high-yielding currency and an increase in the lower-yielding
currencies
...

The above scenarios may result from new economic data, speeches
or reports from central banks, or, in the case of the fourth scenario, a reduction in market conﬁdence, eroding risk appetite due to market declines
or geopolitical events
...
Conversely, the unwinding of carry trades can
be accelerated by the execution of multiple margin calls and the subsequent opening of new positions, triggering further selling in high-yielding
currencies
...

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Japanese Yen and Swiss Franc:
Thriving During Uncertainty
Due to structurally low interest rates in Japan and Switzerland, the yen
and the franc often served as funding currencies, used by speculators to
borrow in lower rates and invest the proceeds in higher-yielding currencies
and other assets such as gold, oil, and equities
...
A surplus in the current
account signiﬁes that both countries’ exports of goods and services are
greater than their imports
...

By contrast, countries with high current account deﬁcits such as the
United States or the United Kingdom command higher interest rates because they require capital from abroad to ﬁnance these deﬁcits
...
S
...
Generally, the wider the current account deﬁcit, the higher the
required ﬁnancing from abroad and the higher the cost of ﬁnancing—hence
the interest rate
...

Just as a person with $20,000 in credit card debt is more likely to be
charged a higher interest rate than someone with a $2,000 credit debt, current account deﬁcit nations incur higher interest rates and their currencies
are said to be riskier than those of current account surplus nations
...

Figure 5
...
New Zealand,
the United States, Australia, and the United Kingdom each have current account deﬁcits and boast higher interest rates than in Japan and
Switzerland, whose lower interest rates are explained by current account
surplus balances
...
When Canada’s current account balance became positive in early 2000, interest rates fell from 5
...
0 percent in 2002
...

Yet the relationship between current account balances and interest
rates remains clear
...
0
Current Account Percent of GDP

15
...
0

5
...
0

–5
...
0
NZ

US

AUS

UK

EUR

CAN

JAP

SWITZ

FIGURE 5
...

considered risk-seeking trades, or reﬂective of rising risk appetite
...
An illustration of the development in global interest rates
such as in Figure 5
...

High Interest in Yen’s Low Yield
While both the Japanese yen and Swiss franc are characterized by their
low-yielding status, the Japanese yen is more notorious for its sharp declines during the accumulation of carry trades as well as for its rapid gains
during the unwinding of carry trades
...
3 trillion is the world’s second
largest, more than 10 times the size of the Swiss economy
...

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Risk Appetite in the Markets

The Path of Rates Is Essential
8
7
AUS

UK

6

Percent

5
4

CAN

USD

E-15

3
2
SWZ

1

JPN

0
May-08

Jan-08

Sep-07

May-07

Jan-07

Sep-06

May-06

Jan-06

Sep-05

May-05

Jan-05

Sep-04

May-04

Jan-04

Sep-03

May-03

Jan-03

Sep-02

May-02

Jan-02

FIGURE 5
...

Once the Japanese equity bubble burst in the early 1990s, the Nikkei225 Index lost 40 percent in 1990 and 76 percent into 2001, erasing over
US$7 trillion of wealth in a decade
...
5 percent peak in 1990 to below 1 percent in 1998 as the central bank
aggressively slashed its discount rate target from 6 percent in 1990 to 0
...
Figure 5
...

As Japanese interest rates plummeted near zero, the acceleration of
carry trades out of the yen triggered a broad damage in the currency
...
60,
an 85 percent increase from the April 1995 low of 79
...
S
...
As yen shorts piled up, so did everything else ﬁnanced with the carry
trade, and the decline in the Japanese currency continued
...
4 highlights how Japan’s ultralow interest rates fueled the carry trades into higher
interest rate currencies of the United States, Germany, and the United
Kingdom
...
The Asian currency

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Japanese Interest Rates after the 1980s Bubble Burst
45000

7
...
0
5
...
0

25000

3
...
0

15000

Nikkei-225

35000

Overnight Rate (Percent)

Nikkei-225
Japan Rate

1
...
0
Jan-89

Jan-92

Jan-95

Jan-98

Jan-01

Jan-04

Jan-07

FIGURE 5
...

Low Japanese Rates Feed the Global Carry Trade
UK
Japan

Interest Rates (Percent)

9

Germany
USA

7
5
3
1
–1

–3
Jan-08

Jan-07

Jan-06

Jan-05

Jan-04

Jan-03

Jan-02

Jan-01

Jan-00

Jan-99

Jan-98

Jan-97

Jan-96

Jan-95

Jan-94

Jan-93

FIGURE 5
...

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crisis of 1997 did not dissuade investors from piling onto high risk
economies with swelling current account deﬁcits
...
Investors who
had borrowed in low-yielding yen to exploit Russian interest rates as high
as 140 percent stampeded back into yen, which consequently soared across
the board
...
60
...
70
to 118
...

The episode of autumn 1998 was the ﬁrst major example of the unwinding of yen carry trades
...
The result was an 88 percent plunge in households’
interest income, which further dented an already damaged consumer purchasing power
...
Japanese savers
hungry for yield and non-Japanese investors exploiting low yen borrowing costs used the yen as a funding means to invest in higher-yielding
currencies, equities, and commodities
...

In contrast, interest rates in the United States, the United Kingdom, the
Eurozone, Australia, and New Zealand averaged a monthly rate of 3
...
8 percent, 3
...
4 percent, and 6
...

The interest rate deﬁcit was too great to ignore by Japanese savers and
investors
...

Investors then shifted toward foreign bond funds, which offered higher
yields as well as monthly dividend payments aimed not only at enhancing
interest income but also to offset any potential decline in the value of the
bonds
...
But
this time it was through online-based foreign exchange margin trading,
whereby speculators use leverage to control regular-size contracts with deposits 50 to 100 times less than normal size
...
The rate differential is then further
enhanced or offset via the resulting currency ﬂuctuations
...
S
...
Their role of the yen carry
trade was behind the biggest one-month decline in the USD/JPY exchange
rate in October 1998, and proved its presence once again in 2007 and 2008
...

Conversely, proﬁt-taking in stocks and commodities was inversely related with a rebounding yen
...
Figure 5
...
As the tightening cycle extended into
June 2006, the two-year period was accompanied by a rise in the USD/JPY
rate
...

S&P 500 versus USD/JPY
150

1,700
S&P 500
USD/JPY

1,600

140

1,500

130

1,300
120

1,200
1,100

USD/JPY

S&P 500

1,400

110

1,000
900

100

800
10/14/2007

3/18/2007

8/20/2006

1/22/2006

6/26/2005

11/28/2004

5/2/2004

10/5/2003

3/9/2003

8/11/2002

1/13/2002

6/17/2001

11/19/2000

4/23/2000

9/26/1999

2/28/1999

8/2/1998

1/4/1998

700

90

FIGURE 5
...

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121

USING RISK APPETITE TO GAUGE
FX FLOWS
The aforementioned cases illustrate the straightforward nature of carry
trades
...
As will be seen later in this chapter, carry trades
are also used to invest in higher-yielding assets, beyond interest-bearing accounts denominated in foreign currencies
...
But, as we also have seen, regardless
of the target investment, investors will always run the risk of sustaining a
decline in the value of the target currency (currency risk), a rise in the
funding currency, or a decline in the interest rate differential (yield risk)
...
Just as she bore the
risk of a decline in the price of shares, carry trade investors bear the risks
of a falling yield, a declining target currency, and/or a rising funding currency
...

Understanding the various gauges of risk appetite is essential in grasping the dynamics dictating currency movements in the short and medium
term
...
The four measures most often used as
yardsticks in assessing risk appetite shaping currency markets are (1) equity indexes, (2) the volatility index (VIX), (3) speculators’ futures commitments, and (4) corporate bond spreads
...
Such cases reﬂect eroding market
conﬁdence arising from worries about the economy, negative geopolitical
events, and mounting systemic risk
...
S
...
Although
it focuses on companies with large capitalization, the index covers about
75 percent of U
...
equities, making it a suitable proxy for the total market
...
M
...
Hong Kong’s Hang Seng’s index and
China CSI 300 Index are useful for gauging sentiment in the Asia-Paciﬁc
area
...

Figure 5
...
Being the
most-sought currency in carry trades, the Japanese yen exhibited a near
perfectly negative correlation with the Dow and the Nikkei as investors
funded their equity positions with cheap yen loans
...
The result was a simultaneous decline in the yen versus
most major currencies and a rally in major equities
...
e
...

The strength of the yen-stocks relationship is especially highlighted by
its near consistency over several time frames
...
Oftentimes, for instance, during the period between third quarter 2007 and ﬁrst quarter 2008, the S&P 500 sold off sharply
in the last 30 minutes of trading
...
5 percent to 1
...
Consequently
Global Stocks Rally at Expense of Falling Yen
23,000

150
Nikkei
Dow Jones Ind
Yen Index

21,000

140
130

17,000
120
15,000
110
13,000

Yen Index

Dow Nikkei

19,000

100

11,000
9,000

90

7,000

80
Jan-08

Jul-07

Jan-07

Jul-06

Jan-06

Jul-05

Jan-05

Jul-04

Jan-04

Jul-03

Jan-03

Jul-02

Jan-02

Jul-01

Jan-01

Jul-00

Jan-00

FIGURE 5
...

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we would see notable gains in the Japanese yen against most currencies as
risk reduction appetites dominate the market
...
S
...
M
...
M
...
The existing move (the yen rally) may be further prolonged in the
Tokyo session as the lack of conﬁdence in the U
...
market spills over to
Asian trade, prompting traders there to further unwind the carry trades
and boost the yen
...
Aside from the magnitude, one must discern whether the sell-off is a result of factors conﬁned to
a speciﬁc company, or related to a macroeconomic/ﬁnancial market issue,
which is part of a concern with the economy
...

The Volatility Index
The volatility index (VIX) measures the volatility of a wide range of options on the S&P 500 Index and is used to gauge the markets’ expectations
for volatility over the next 30 days
...
Low values may also reﬂect
complacency arising from overconﬁdence with a rising market, or exuberance
...
During the market
crash of October 1987, the VIX shot up to a record high of 172 from the
mid-20s in the prior week
...
7 shows how the VIX shot up in periods of extreme volatility, which were accompanied by sharp declines in equities
...

The advantage of using the VIX over stock indexes in gauging potential
shifts in risk appetite is partly related to the components used in calculating
the VIX index, namely the implied volatilities of various index options
...

Thus, sudden moves in stock indexes sometimes result from an aberration
in a few selected stocks or simply proﬁt-taking, in which case the impact
may weigh on the broader index but is no indication of any shift in risk
...
S
...
S
...
7 The VIX rallied during all major risk-triggering events
...
But
the main advantage of the VIX over equity indexes is its use as a benchmark
reference for risk, hence offering a neutral perspective on market risk and
appetite without referring to the price equities, and therefore the ability to
pinpoint how sell-offs or rallies evolve
...
5 percent
...
But if the same equity developments are accompanied by more modest gains in the VIX, then there
may be little inferred from the pullback in equities
...

Using VIX in Exposing Complacency While much has been said
about the efﬁcacy of the VIX to expose rising fear in the market, the index
also deserves at least the same amount of ink spilled for its ability to expose
rising risk appetite, sometimes also known as rising complacency
...
8 illustrates how the most prolonged periods of relatively low volatility
coincided with a phase of rising equities, characterized by rising bullishness and heightened investor conﬁdence in the stock market
...

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S&P 500 versus Volatility Index
50

1,700
VIX

45

S&P 500

1,600
1,500

40

1,300
VIX

30
1,200
25

S&P 500

1,400

35

1,100
20

1,000

15

900

10

800

5

700
Jan-08

Jul-07

Jan-07

Aug-06

Feb-06

Aug-05

Mar-05

Sep-04

Mar-04

Sep-03

Apr-03

Oct-02

Apr-02

Oct-01

May-01

Nov-00

May-00

Nov-99

Jun-99

Dec-98

Jun-98

Jan-98

FIGURE 5
...

Phases of increased risk appetite are often accompanied by a rise
in carry trades as improved conﬁdence drives investors to borrow lowyielding currencies to buy higher-yielding currencies, equities, and commodities
...
Currencies of current account deﬁcit countries are said to be riskier and
hence pay high interest rates
...

Figure 5
...

Note how investors exploited declining volatility between 2004 and 2006 by
aggressively selling the yen against higher-yielding currencies as their conﬁdence toward risk increased
...

Aside from improved risk appetite and intensifying advances in equities, the initial decline in the yen had been especially magniﬁed by the prevailing interest rates landscape
...
9 USD/JPY and VIX hand in hand as yen is sold against the dollar to
scale up on risk appetite
...

As they announced their rate hikes, the Federal Reserve, Reserve Bank of
Australia, and Reserve Bank of New Zealand were signaling further increases as part of their commitment to contain inﬂation
...
25 percent in Japan
...
25 percent, 4
...
25 percent, 7
...
00 percent respectively
...
5 percent and 2
...

Eventually, in July 2006, the Bank of Japan delivered its ﬁrst rate hike
in six years, raising the benchmark overnight rate target to 0
...
15 percent, a decision that had minimal effect in staving off speculators from selling the yen after the central bank had widely telegraphed
the rate change that was long overdue
...
Attempting to end years of deﬂation, Japanese policy makers were loath in exacerbating the decline in prices via renewed yen strength
...
Hedge funds,
bank dealers, corporate treasuries, and even Japanese housewives saw
little risk in borrowing in yen and placing the proceeds in the rallying
aussie, greenback, loonie, kiwi, and British pound, as well as equities and
commodities
...
The
accumulation of yen carry trade ﬂows was faced with periodic disruptions,
triggered by sporadic bouts of risk-reduction episodes
...

Volatility would later return with a vengeance in 2007, dealing U
...
and
global markets punishing blows on increased evidence that the slowdown
in U
...
housing had spilled over to the rest of the economy
...
U
...
markets already reeling from Chinese
markets and the rest of the Asian continent took a turn for the worse on
reports that an attack on a U
...
8 percent decline in U
...

durable goods
...
3 point loss in the S&P 500, or a
3
...
The
Dow Jones Industrial Average tumbled 416
...

On that eventful week of tumbling stock markets and sharp reduction
in risk appetite, the yen rose 4 percent against the dollar and the euro,
5 percent against the Aussie and the pound, and 7 percent against the kiwi
...

The volatility-ﬁlled period of January 2007 to March 2008 is illustrated
in Figure 5
...
The mirror image was reﬂected in the falling EUR/JPY
as the unwinding of the yen carry trade meant rapid ﬂows into the Japanese
currency away from EUR and all other major currencies
...
10 EUR/JPY reﬂects a mirror image of the VIX as soaring volatility
drives capital back to JPY
...
S
...
Thus, carry trades into the yen and their
unwinding are not limited to USD/JPY but extend to EUR/JPY, AUD/JPY,
NZD/JPY, GBP/JPY, CAD/JPY, and so on
...
S
...
Clients of hedge funds rushed to withdraw their money while money
managers sold their existing holdings to meet clients’ requests and meet
margin calls
...
In the week ending August 17, 2007, the yen soared 6 percent, 8 percent, 15 percent, and 16 percent against the USD, EUR, AUD,
and NZD, respectively
...
Figure 5
...
95

38
VIX
AUD/USD
NZD/USD

0
...
8
0
...
7

VIX

AUD/USD, NZD/USD

0
...
65
13

0
...
55

8
4/10/2008

2/26/2008

1/14/2008

11/29/2007

10/17/2007

9/5/2007

7/24/2007

6/11/2007

4/27/2007

3/15/2007

1/31/2007

12/14/2006

11/1/2006

9/20/2006

8/8/2006

6/26/2006

5/12/2006

3/30/2006

2/15/2006

1/3/2006

FIGURE 5
...

high-yielding currencies such as the aussie, kiwi, and sterling versus their
lower-yielding counterparts
...
S
...
Consequently, the Federal Reserve was forced
to complete its about-face turn in policy priorities from containing inﬂation to reviving growth and slashing interest rates by 225 basis points in
four months, 125 basis points of which were cut in nine days
...

The data are broken down into commitments by commercial players (usually made up of businesses aiming to hedge currency risk) and speculators (traders buying and selling contracts purely for reaping the gains from
price changes)
...

Considering that excessive yen purchases are a reﬂection of escalating risk appetite, one can discern the extent of carry trades via the trend
in the yen shorts—the amount of yen-selling contracts versus the dollar
...
12 shows the clearly positive correlation between speculators’
commitment in the yen and the value of USD/JPY
...
12 Fed hikes in 2004–2006 extended USD/JPY gains by lifting interest
in short JPY contracts versus USD
...

The low-yielding Swiss franc is another currency used for funding
carry trades and is thereby subject to considerable gains during the
unwinding of carry trades
...
13 highlights the deviation of commitments in the yen and the Swiss franc (“swissy”) from commitments in other
currencies between January and September 2007 as JPY and CHF were
sold to ﬁnance the rise in equities and risk appetite
...

The relationship between risk appetite and the low-yielding CHF and
JPY stands out in Figure 5
...
In 2004–2007, market volatility fell to multiyear lows, reﬂecting heightened investor conﬁdence in global equities
...

One drawback to using futures speculators’ commitments report is the
one-week lag of the data and, hence, the possibility of falling behind the
trend and chasing a runaway market
...
Say, for instance, that net yen shorts

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131

Risk Appetite in the Markets

Swiss and Yen Futures Stand Out from the Rest
Yen and Franc Net Positions (Thousands)

130

80

30

– 20

– 70

CHF
JPY
EUR
AUD
GBP

– 120

– 170

– 220

Jan-07

Mar-07

Jun-07

Sep-07

Dec-07

Feb-08

FIGURE 5
...
But subsequent market decline unwound CHF and JPY
shorts amid sharp reduction in appetite
...
14 Falling VIX is positively correlated with falling interest in yen and
franc futures due to heightened global investor conﬁdence
...
One could then conclude that the yen carry trades are reaching
unsustainably high levels, possibly leading the way for someone to build
a contrarian trade to buy the yen
...
Once having reached levels judged too extreme,
ﬁnancial markets require little in the way of catalysts to trigger reversals
...

Speculative futures’ commitments are a fundamental gauge of sentiment in currency markets
...
Combining futures ﬂows in
currencies with risk signals such as the VIX offers valuable insight on the
prevailing currency trend
...
S
...

High-Yield Corporate Spreads
Another way to gauge the extent of market risk-taking and corporate conﬁdence is via corporate spreads, which measure the difference between
high-yield corporate bonds (also known as junk bonds) and U
...
government bonds of similar maturities
...
With
U
...
government debt considered to be the least risky from the perspective
of credit risk (chances of default), yields on government Treasury bonds
(Treasuries) are relatively lower than those on corporate bonds, especially
as companies face credit, business, and inﬂation risk
...

This means that the spread between corporate bond yields over treasuries yield is lower as the price of high-yield corporate bonds pushes
higher
...

Just as a rising VIX tends to reﬂect increased volatility (fear) in the
general market, rising bond spreads are indicative of emerging worries
with corporate ﬁnances, which is more likely to be the case during market

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Risk Appetite in the Markets

uncertainty and/or economic slowdown
...
And, similar to the VIX, excessively low
spreads can be a sign of investor complacency and a disregarding of the
risks associated with high-yield bonds
...
15
...
Sometimes, market fear escalates and spreads rise while
the macroeconomic fundamentals remain solid
...
This is manifested in the
chart between June 2004 and April 2007, a period of advancing U
...
and
global equities, plentiful liquidity, and booming mergers and acquisitions
...
Currency market participants therefore can pick up a few clues about the prevailing trends in bond spreads so as to determine the general state of conﬁdence and risk aversion in the market
...
15 Corporate bond spreads measure credit risk while VIX measures
market volatility
...
In such a scenario, one could surmise that an
eventual widening of bond spreads is near, which may fuel the existing
increase in risk aversion once junk spreads begin to increase
...
But it takes more than yield differentials to prompt traders into borrowing in low-rate currencies
...

TYING IT ALL TOGETHER: 1999–2007
When correlating risk appetite to currencies in a real-world scenario, we
ﬁnd a fairly strong correlation between rising risk aversion and a strengthening in the Japanese yen and the Swiss franc
...
An increasing
level of fear causes carry trades to be unwound from high-yielding assets
and back into the lower-yielding yen and franc
...
1 illustrates this relationship between 1999 and 2007 using
stocks, VIX, and high-yield bond spreads as measures of risk, while the yen
and franc are used to represent the funding currencies
...
Declines in the broad equity indexes, as measured by the S&P
500, are accompanied by increases in the VIX
...
As risk appetite declines, traders scale down their shorts in the yen and the franc, prompting
a strengthening in these currencies
...
S
...

In event 3, yen futures fell during September–December 2000 as markets
continued unwinding the yen longs, which ensued during the preceding
two months
...
Meanwhile, currencies
had posted the bulk of their pre-Iraq war gains versus the U
...
dollar in
September–December 2002 as U
...
and U
...
support in favor of an attack
on Iraq intensiﬁed, rendering war a stronger probability
...
1999
Jan
...
2000
Sep
...
2000
Feb
...
2001
Sep
...
2002
Jan
...
2003
Mar
...
2005
Sep
...
2005
May–June 2006
Feb
...
2007
July–Aug
...
–Mar
...
S
...
11 attacks
Stocks sell-oﬀ hits ﬁve-year lows
Pre-Iraq war nervousness, WMD speculation
Rising U
...
inﬂation triggers rate fears
Hurricanes Rita, Katrina
Fears of BoJ hike, emerging markets
China stocks tumble, U
...
subprime
Losses in U
...
funds on subprime
Rising write-downs in U
...
banks

Event Description

TABLE 5
...

In event 8, the low-yielding yen and franc, along with most major currencies, fell against the U
...
dollar as the Federal Reserve vowed to prolong
its rate hike campaign to contain rising inﬂation
...
S
...

In event 9, both the yen and the franc sustained losses as part of a general dollar rally being prompted by prolonged Fed tightening
...
Note how corporate bond spreads rose
by a mere 11 percent as the market deemed the fundamentals of corporations’ debt-paying ability to remain strong despite the hurricanes
...

Interest rate differentials will always be around, moving as a function
of traders’ expectations, economic data, central bank action, and sentiment
...
Rather than getting on the bandwagon and chasing a trend, it is imperative that one discern the drivers of
the trend and the varying dynamics of risk appetite
...
In today’s
world, where currency ﬂuctuations are increasingly correlated with equity market volatility, forex participants can no longer afford to look only
at currencies
...
Whether traders are piling up on shorting low-yielding
currencies, scaling down their carry trades, or simply selling the U
...
dollar
across the board, this combination is essential in determining the principal
force behind current sentiment
...

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CHAPTER 6

Reading the Fed
via Yield Curves,
Equities, and
Commodities

he relationship between foreign exchange rates and interest rates remains a principal force in determining currency trends and values
...
The ability to predict future moves in interest rates of the world’s
major central banks hinges on a strong grasp of a nation’s economic pulse,
of its most inﬂuencing macroeconomic variables and ﬁnancial market indicators
...

The United States continues to be the world’s largest economy as well
as a major inﬂuence on global economic growth, despite a gradual waning in such inﬂuence as of late
...
S
...
S
...
Meanwhile, as of 2007, the U
...
dollar accounted for 86 percent of
the average daily foreign exchange market turnover, compared to 37 percent for the euro
...
And the
EUR/USD pair continues to dominate currency trading, accounting for
27 percent of the daily turnover in global currency markets as of 2007
...
S
...
Other
USD-related pairs also respond to U
...
-speciﬁc factors, but the popularity
of the EUR/USD pair makes it a consistent mover to these events
...
S
...
S
...

This chapter does not cover the determinants of interest rates and central bank decisions
...
This chapter also explains how
to use the relationship between gold and oil prices in gauging the direction
of the overall economy and its implications for Federal Reserve policy
...

Unlike the coupon interest rate, which is the ﬁxed payment to bondholders, the yield to maturity measures the total return an investor receives by
holding the bond until it matures, regardless of whether it pays a coupon
rate
...
The governments of the United States and other countries with robust bond markets raise funds by issuing bonds with different time durations to banks
and other national governments
...
The bonds, like any other IOU, promise to pay interest at a stated rate throughout the life of the bond, followed by the full
principal at maturity
...
The middle of
the curve includes interest rates on maturities ranging from 3 to 7 years,
while the long end shows interest rates from 10 to 30 years
...
Monetary
policy is primarily driven by interest rate announcements, open market operations (buying and selling of government securities to manage liquidity),

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Reading the Fed via Yield Curves, Equities, and Commodities

139

and bank reserve requirements
...
Once these bonds are resold in the secondary
market, their supply and demand determines prices and yields
...

Rising expectations of inﬂation or an actual increase in inﬂation outstrips
the ﬁxed income of bonds’ coupon payments, thereby reducing the value
of the bonds and boosting their yield to maturity
...
Conversely, falling inﬂation and/or weak economic reports
are usually favorable for bond prices and negative for their yields
...
A popular measure is the difference between yields on 10- and
2-year government securities, known as the 10-2 spread
...

TYPES OF YIELD CURVES
Due to the time value of money, bonds with longer maturities pay higher
interest rates than bonds with shorter maturities
...
As a result, the shape of the
yield curve is positively or upward sloping
...
1 illustrates an upwardsloping or normal shaped curve dated July 18, 2007, and a less steep or ﬂatter yield curve on June 6, 2007
...
In this
case, however, the buildup of the upward-sloping curve in July 2007 was a
result of worsening economic conditions, which were priced in the ﬂatter
yield curve
...

Flat yield curves usually signal an approaching economic slowdown
or expansion, depending on which stage of the economy had initially prevailed
...
Figure 6
...
1
5
...
95
June 6, 2007
4
...
85
July 18, 2007
4
...
75
2 year

3 year

5 year

7 year

10 year

FIGURE 6
...

Flat Yield Curve

Yield (Percent)

4
...
8

4
...
2 Yield curve moved from an inverting to a ﬂattening formation in late
March, 2006 as the cooling economy began to feel the Fed’s 2004–06 rate hikes
...
On the long end of the curve, bond
traders are no longer pricing the chance of rising inﬂation due to their anticipation of slower growth ahead
...
S
...
Followers of equity markets ended up being largely misled when the
economy slowed later in the year and the Fed was forced to cut rates three
months later
...
At this stage, traders of 10- and
30-year Treasury securities are certain the economy has reached bottom
and begin to project higher inﬂation and interest rates in the distant future,
thereby raising long-term yields
...

Inverted yield curves usually signal economic slowdowns and are often
a harbinger of recession
...
Historically, yield curve inversions have started
about 12 to 18 months before a recession
...
3 illustrates the inverting
formation in January 2007, suggesting that short-term rates were too high
relative to the bond market’s forward-looking interest rate outlook as seen
farther down the curve
...
9

4
...
7

2 year

3 year

5 year

7 year

10 year

FIGURE 6
...

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CURRENCY TRADING AND INTERMARKET ANALYSIS

RATIONALE OF INVERTED YIELD
CURVE IMPLICATIONS
The main reason inverted yield curves have presaged economic weakness
is that they narrow the premium gained by banks between the short-term
interest rates paid out to depositors and the longer-term interest rates
earned on loans
...
Asset
managers selling short-term bonds and buying long-end bonds get squeezed
out when the cost of their short-term debt increases relative to their longermaturity holdings
...
Negative-yield spreads
then become self-enforced when long-term yields remain pressured by expectations of low inﬂation, slowing growth, or both
...
Figure 6
...
Of the eight recessions between 1957 and 2008, only the ﬁrst two recessions (1957–1958
and 1960) were not preceded by an inverted yield curve
...
The exceptions of the 1950s and 1960s may be discounted
due to the relatively low levels of depth and size of ﬁnancial markets
50 years ago, and the different mechanism by which the Fed managed
monetary policy at the time
...
Recessions are extensions of economic
downturns, which were signaled by yield inversions and consequently triggered interest rate reductions
...
5
...
4 Yield curve’s signal detection is also eﬀective by 10-year Treasury
yield minus Fed funds rate
...
The charts also show that in 1995 the yield curve was
close to inverting but a series of Fed rate cuts that year quickly normalized the yield curve and averted recession
...
The brief yield curve inversion of summer 1998 was the
other example in the chart where no recession occurred, but the ensuing
global market crisis did shed 20 percent off U
...
stock indexes, prompting
the Federal Reserve to cut rates in three consecutive months
...

GREENSPAN’S “CONUNDRUM” PROVED
BERNANKE’S PROBLEM
When the Federal Reserve normalized monetary policy by raising interest
rates from their 1 percent low in 2003 to 5
...
Two-year yields rose from 1
...
27 percent in June 2006,
while 10-year yields rose from 4
...
20 percent level,
matching their two-year yield counterpart
...
5 Yield curve’s track record is validated by developments in employment and manufacturing
...
frbsf
...
pdf)
...
Greenspan then
introduced an explanation that was later expounded on by his successor,
Chairman Ben Bernanke
...
S
...
As the U
...
current account deﬁcit soared
from $300 billion in 1999 to over $800 billion in 2006, the imbalance was
increasingly translated into rising surpluses in developing countries
...
In the case of
East Asian economies, the hard lessons of the 1997–1998 currency crises
prompted these nations into rapid accumulation of exchange reserves and
a higher rate of savings
...

The bulk of these surpluses were channeled into U
...
and non-U
...

government securities, to the extent of depressing long-term global interest rates
...
S
...
04 percent in 2000 to 4
...
In Germany, it fell from
5
...
38 percent; in the United Kingdom it fell from 5
...
42 percent; and in Canada it fell from 5
...
07 percent
...
The other explanation for lower long-term
rates was the surge in pension funds’ investments in long-term bonds as
long-term liabilities were prolonged by shifting demographics
...
This
made plenty of sense as Asian emerging economies accumulated massive
amounts of foreign exchange reserves, and recycled the bulk of it by buying U
...
Treasuries to keep their currencies competitive
...
The latter
part of the next section demonstrates the early signs of disagreement between the apprehensive economic assessment of the bond market and the
rosy assessment of the Federal Reserve and U
...
Treasury throughout 2006
and early 2007
...
S
...
S
...
The charts
in Figure 6
...

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CURRENCY TRADING AND INTERMARKET ANALYSIS

Short- and Long-Term Rates' Recessionary Signal
9

Percent

7

10-Year Yield

5

Fed Funds
3

Percent Year over Year

1
8
GDP
Growth

6
4
2
0
–2

S&P 500

1576
1376
1176
976
776

2/19/08

8/7/2007

1/25/07

7/13/06

12/29/05

6/20/05

12/7/04

5/26/04

11/12/03

5/5/03

10/21/02

4/11/02

9/27/01

3/13/01

8/29/00

2/17/00

8/9/99

1/27/99

7/16/98

1/2/98

FIGURE 6
...

1998 Yield Curve Inversion
Starting with the top chart, we see how a brief ﬂattening in the yield curve
in summer 1998 saw the 10-year yield falling toward the level of the Fed
funds rate, ultimately prompting a slowdown in GDP and an 18 percent
decline in the S&P 500 in the three months ending October 1998
...
The Federal Reserve cut
the Fed funds rate target by 25 bps in September, October, and November,
bringing the rate down to 4
...
The rate cuts were largely addressed at a sudden plunge in bond market liquidity and deteriorating
global investor conﬁdence, rather than slowing U
...
economic activity
...

For currency traders, the inversion of June 1998 had not only foretold
the beginning of the autumn 1998 rate cuts, but also signaled the peak of
the U
...
dollar in mid-August 1998
...
In trade-weighted terms, the dollar index peaked 11 days after the
beginning of the yield curve inversion, falling 9 percent in the ensuing two
months
...
Investors
who had borrowed in low-yielding yen to invest the proceeds in higheryielding emerging debt—including Russian government paper yielding as
much as 140 percent—were knocked out of their positions when Russia
chose to default in its debt and let its currency slide
...
6 took place in the ﬁrst
quarter of 2000, when the decline of the 10-year yield was prolonged toward the 6
...
Note that no period of ﬂat
yield curve prevailed prior to the curve inversion as the Fed’s rate hikes
of 2000 were relatively more abrupt than in other tightening phases when
rate increases were well communicated
...
5 percent to a 45-year low
of 1 percent
...
S
...
S
...

The currency impact of the 2000 yield inversion materialized in late
November 2000 when the Federal Reserve made a 180-degree turn in its
policy bias
...
The rate cut marked the start of the 2
...
5 percent to 1 percent
...
But the dollar, along with the rest of these currencies,
strengthened against the yen as Japan’s economy displayed another false
awakening from its 1990s recession
...
6 began in late 2005, and turned
into an inversion in 2006–2007 as bond traders sent long-term rates down
on the expectation of slowing economic growth
...
”1
Figure 6
...
Investors who heeded the speeches
of Federal Reserve ofﬁcials in 2006 and early 2007, warning persistently
about the dangers of inﬂation while comforting the public about the housing correction, had every right to expect a rate hike in late 2007 or early
2008
...
S
...
S
...

The Fed maintained with conﬁdence that the overall economy would
remain immune to the housing slowdown, which it described as being
largely conﬁned to the subprime lending market
...
6 percent in
ﬁrst quarter 2006 to subpar growth rates of 2
...
1 percent, 2
...
6 percent in the ensuing four quarters
...
8 percent and 4
...
S
...
But the
net increase in GDP overlooked the prolonged dislocations in the housing
market and the resulting deterioration in market liquidity
...
Bernanke, 2007 International Monetary Conference, Cape Town, South
Africa, http://www
...
gov/newsevents/speech/bernanke20070605a
...

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149

Reading the Fed via Yield Curves, Equities, and Commodities

1,500
S&P 500

3
...
5
2
1
...
5
0
–0
...
5

200

1

100

0
...
5

Jan-08

Oct-07

Jul-07

Apr-07

Jan-07

Oct-06

Jul-06

Apr-06

Jan-06

Oct-05

Jul-05

Apr-05

Jan-05

FIGURE 6
...

new heights, global investor conﬁdence soared, and risk appetite pushed
carry trades to new heights at the expense of multiyear lows in the
Japanese yen
...

In July 2007, ﬁnancial markets eventually gave in as credit rating agencies downgraded tens of billions of securities, which were backed by
loans and mortgages with poor credit quality
...
In August, market interest rates soared as
credit institutions lacked the conﬁdence to lend and borrow, bringing interbank lending to a virtual halt
...

Just nine days after the Federal Reserve announced holding rates unchanged at 5
...
Less than two weeks
after it had stated that the “downside risks to growth have increased somewhat,” it altered the qualiﬁer to “increased appreciably,” without mentioning a word on inﬂation
...

Once again the dollar had complied with the law of the yield curve
inversion
...
S
...
The currency then consolidated
during the ﬁrst eight weeks of 2006, before cementing a peak in the second week of March 2006
...
What would later ensue was a gradual deterioration in dollar
sentiment, accelerating in April and May 2006, when the Federal Reserve
signaled the end of the two-year rate hike campaign
...
30 level last attained in April 2005 as U
...
economic growth
underperformed that of the Eurozone, the United Kingdom, Canada,
Australia, and even Japan
...
Markets began expecting interest rate cuts in the United States while the rest of the
world was in the midst of raising theirs
...
The housing recession spread to all parts
of the U
...
economy and corroded the normal functioning of credit markets
...
S Dollar Index hit the lowest level in its 40-year history, reaching 74
...
The U
...
currency hit record lows against the euro, 32-year lows
against the Canadian dollar, 25-year lows against the New Zealand dollar,
23-year lows against the Australian dollar, 14-year lows against the British
pound, and 5-year lows against the Japanese yen
...
8 illustrates the dollar impact of turnarounds in the U
...

yield curve, showing that curve inversions precede dollar selling by periods ranging from two weeks to nine months
...

Although there exists no clear-cut relationship between yield curve
inversions and the U
...
dollar, recent history has shown a noticeable relationship between the latter stages of the inversion and the value of
the greenback
...
federalreserve
...
htm
...
5

10-2 year
spread

120
USDX

2

110
Percent

1
...
5

80

−0
...
8 Yield curve inversions have generally signaled dollar weakness as
short term yields weaken relative to long term yields
...
As these yield developments are manifested into the market, currency traders begin selling the dollar on the argument that lower U
...
rates
will erode the dollar’s yield differential with other currencies
...
1 dissects the currency and stock market impact of yield
curve inversions from a timing perspective
...
S
...
1 Timing of Dollar Peak, Stocks Peak, and Rate Cuts from the Start of
Yield Curve Inversions

Yield Inversion

January 1989 to
January 1990
June to July 1998
February to
December 2000
January 2006 to
June 2007

Time Elapsed for
Time Elapsed for
Time Elapsed for
Start of Rate Cuts
Peak of USDX after Peak of S&P 500
after the Inversion after the Inversion
the Inversion

5 months

18 months

18 months

11 days
9 months

1
...
Five months later, the dollar index peaked at 104
...
The Fed inaugurated its easing
campaign 18 months after the curve inversion and 13 months after the start
of the dollar sell-off
...

The 1998 inversion resulted from a drying up of global market liquidity
rather than domestic U
...
economic concerns
...
The currency lost 9 percent in the ensuing two months, while the
S&P 500 dropped 17 percent in two months
...

The 2001–2002 recession ofﬁcially began in March 2001, 14 months after the yield curve had inverted
...
The burst of the equity bubble was triggered in March 2000, under the measure of the S&P 500, leading to a 50
percent sell-off that lasted into October 2002
...
But it took the dollar only two months from the January
inversion to descend into a two-year slump in the magnitude of 18 percent
...
It wasn’t until 18 months after
the January 2006 inversion that the S&P 500 hit a peak
...

The aforementioned cases served as powerful illustrations of the consistency of the yield curve’s effectiveness in predicting rate cuts by the
Federal Reserve, when other indicators have pointed otherwise
...
7 percent in the second quarter of
1998 to 4
...
2 percent in the third and fourth quarters, respectively
...
By the end of 1998, the U
...
economy rode on the
coattails of rising productivity, low inﬂation, and a surging stock market,
all of which created the longest uninterrupted period of postwar economic
expansion
...

Perhaps it was no big feat by many to have expected the burst of a bubble
that was largely founded on exuberant price targets when several companies had shown no proﬁts on their books
...

TYING INTEREST RATES
TO THE GOLD-OIL RATIO
The ever-increasing role of commodity prices in global ﬁnancial markets
and its impact on world economies cannot go unnoticed
...
Record
prices in gold and oil have left forecasters rather challenged as these commodities attain unprecedented levels
...
S
...

During the days of the gold-backed U
...
dollar regime of $35 per ounce,
oil prices held up at $1
...
50 per barrel
...

As the devaluation of the U
...
currency eroded the value of oil producers’ exports, the oil cartel was forced to lift prices from less than $2 per
barrel in 1971 to $13 per barrel in 1974
...
0
in 1973, more than tripling its value from the preceding two years
...
S
...
0
...
The overall similarity in the price trend of gold and
oil against the U
...
dollar often leaves traders with little indication as to

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CURRENCY TRADING AND INTERMARKET ANALYSIS

which of the two commands more secular strength and leads the way in
commodity dynamics
...
Figure 6
...
The monthly correlation stood at a robust 78 percent between 1972 and 2007
...
Since 1972, prolonged declines in the gold/oil ratio have proven to be
a drag on the U
...
economy, causing recession in the majority of cases
...
Thus, in many cases, both gold and oil may be on
the rise, but ﬁguring out the pace of increase of one relative to the other is
essential in determining the possible implications to economic growth
...
But in cases where substantial advances in oil are the result of supply factors (political risk, wars, acts of God, labor union action,

40
Gold

35

Gold/Oil Ratio

30
25
20
15

Gold/Oil

Gold $/Ounce

The Gold/Oil Relationship and the Economy
1000
900
800
700
600
500
400
300
200
100
0

10
5
0
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
Jan-86
Jan-85
Jan-84
Jan-83
Jan-82
Jan-81
Jan-80
Jan-79
Jan-78
Jan-77
Jan-76
Jan-75
Jan-74
Jan-73
Jan-72

U
...
GDP Growth
Q /Q (Percent)

16
11
6
1
−4
2008-I

2006-III

2005-I

2003-III

2002-I

2000-III

1999-I

1997-III

1996-I

1994-III

1993-I

1991-III

1990-I

1988-III

1987-I

1985-III

1984-I

1982-III

1981-I

1979-III

1978-I

1976-III

1975-I

1973-III

1972-I

−9

FIGURE 6
...

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155

OPEC action/rhetoric, reﬁnery shutdowns, and falling inventories), oil
prices tend to chart signiﬁcant advances, clearly outpacing any gains in
gold in relative terms and ultimately thereby weighing on the gold/oil ratio
...

Ever since the dollar-gold convertibility was suspended in 1973, each
of the last ﬁve U
...
recessions was preceded by 20 to 30 percent declines
in the gold/oil ratio from its recent highs
...
S
...
” The NBER uses indicators such as employment, industrial production, real income, and retail and wholesale sales
...

1973–1975 Recession
As the dollar prolonged its decline in the aftermath of the 1973 breakdown
of the dollar-gold convertibility, oil prices increased fourfold to nearly $12
per barrel in 1974, triggering sharp run-ups in U
...
gasoline prices and a
subsequent halt in consumer demand
...
But the faster appreciation in the
fuel dragged down the gold/oil ratio from a high of 34
...
2 in October of the same year, before extending its fall to12
...
By 1974–1975, the U
...
economy as well as the major industrialized
economies had fallen into recession
...
Throughout, the gold/oil ratio dropped
from 16
...
0 as gold fell to a two-year low, losing 20 percent while oil
remained steady at around $11 per barrel
...

1980–1982 Recession
A tumbling dollar and record oil prices were the main culprits in the
1980–1982 recession
...
3 in January 1979
to 11
...
The 1977–1979 dollar crisis was already
forcing OPEC to hike prices in order to offset the eroding value of its oil
revenues
...

Note the temporary spike in the gold/oil ratio from 12
...
0 in winter 1980 due to a $400 jump in gold from September 1979 to
January 1980, resulting from the Soviet Union’s invasion of Afghanistan
...

Oil prices, meanwhile, had posted a more modest 33 percent increase to
$38 per barrel than did the invasion-fueled oil, pushing the ratio higher
...
In summer 1981, the gold/oil ratio dipped to a four-year low of 11
...
Rates eventually peaked at 20 percent in
October 1981 before plummeting to 12 percent in January 1982
...
0 in summer 1982, in line with
the deepening 1981 recession which extended into mid-1982
...

1985–1986 Slowdown
In autumn 1985, the gold/oil ratio bottomed at 10
...
9 high in February 1983 in the midst of relative stability in both the metal
and the fuel, coinciding with a peaking Fed funds rate of 8 percent
...
Unlike in the prior cases of falling gold/oil ratios, GDP growth
avoided a contraction, partly due to the offsetting positive effects of the
1986 oil price collapse following OPEC’s decision to lift production
...
The war, the slowdown, and the
rate cuts prolonged an already falling U
...
dollar, which was initiated by
the joint interventions between the United States and major industrialized
countries
...
The oil price jump
dragged the gold/oil ratio by 50 percent to a ﬁve-year low of 10
...
That autumn, the Fed accelerated its interest rate cutting campaign, slashing rates from 8 percent in August to 7
...
The
recession started in fall 1990 and continued until the end of the ﬁrst quarter of 1991
...
S
...
Soaring oil prices of summer 1990 exacerbated the
slowdown and pushed the economy into recession from third quarter 1990
to second quarter 1991
...
OPEC’s miscalculation cut oil prices by
more than half to $11
...
The combination of cheap oil and rising investment spending
fed into a powerful rally in asset prices (stocks and real estate), thus resurrecting global appetite for the fuel throughout 1999 and 2000
...

But the effect of higher oil and rising interest rates from second quarter
1999 to second quarter 2000 transitioned from that of an economic cooling to a prolonged stock market sell-off lasting three long years
...
The Fed began its easing campaign in January 2001 and was forced to reduce rates from 6
...
The ensuing recession and broadening bear market
was predicted by many market strategists, analysts, and reporters
...
0 in 1998 to a nine-year low of 11
...

Despite the recession of 2001–2002 and the prolonged bear market in
equities, the dollar maintained a predominantly strong run, with the exception of a relatively brief retreat from late November 2000 to mid-January
2001
...
But the dollar decline proved limited as traders rewarded the currency due to the Federal Reserve’s aggressive easing, which

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was seen as a means for the U
...
economy to lead the world economy into
recovery mode
...
Oil ended that year at $61 per barrel, up more
than 100 percent over the prior two years, compared to a 54 percent increase for gold over the same period
...
7 in August 2005, its lowest level over the past 35-year history
...
China’s demand was also notable in heavy industry commodities, especially in copper and gold
...
S
...
By the time more stable
oil prices and faster gold appreciation in ﬁrst quarter 2006 lifted the ratio
off its lows above the 10
...
S
...
8 percent
that quarter to 2
...
1 percent, and 0
...
The S&P 500 lost more than 7 percent between
May and June and the USD Index shed 8 percent between March and May
...
Although the 2005 decline of the
gold/oil ratio was not followed by a recession or Fed rate cuts in 2006, the
U
...
central bank did halt its three-year-long tightening campaign in June
2006 due to the broadening housing slowdown
...

Just as the yield inversion beginning in January 2006 correctly signaled
the ensuing decline in the U
...
economy, the 2006 decline of the dollar, and
the 2007 rate cuts, so did the slide of the gold/oil ratio in 2005
...
5
...
S
...

CONCLUSION
The most cogent conclusion to be drawn from the preceding dynamics is
that a bottoming in the gold/oil ratio has most often accompanied a peak
in short-term interest rates, which was later followed by interest rate cuts
...
Recessions were triggered in four out of the ﬁve cases, with
the exception of case 3 (fourth quarter 1985) due to the positive growth
implications of the 1986 oil price collapse
...
Such interaction is more appropriately measured by the gold/oil ratio
rather than, say, comparing the percentage increase of both
...

The tremendous multiplicity of market- and economic-related materials inundating investors has generally helped them improve their grasp
of the main drivers of ﬁnancial markets as well as the functioning of basic macroeconomic relationships
...
The increased tendency for divergence between equities
and the economy has also challenged the understanding of prevailing and
future developments
...

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CHAPTER 7

U
...
Imbalances,
FX Reserve
Diversiﬁcation,
and the
U
...
Dollar

ver the past 10 years or so, it has become impossible to discuss
the present or future value of the U
...
dollar without addressing
the deﬁcits in the U
...
current account, trade, and budget balances
...
Until the new millennium, these imbalances ﬁlled the editorials
of ﬁnancial and mainstream media and dominated the conversation among
investors, economists, and politicians, yet failed to derail the U
...
dollar
from its position as the world’s top reserve and invoicing currency
...
S
...
S
...

The progression of these imbalances has given rise to two opposing
schools of economic thought
...
S
...
S
...
The other school of thought
warns that foreign investors could soon stop ﬁnancing these deﬁcits, thus
triggering a shortage of capital ﬂows, a jump in interest rates, a plunge in
the dollar, and ultimately a severe and prolonged recession
...
S
...
But the unfolding developments of the US economy in 2007–2008 and the resulting
deterioration in the value of the dollar have signiﬁcantly impaired the overriding assumption behind this view that foreigners will maintain their zeal

O

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for U
...
assets, regardless of the strength in economic growth and the value
of the currency
...
S
...
The dollar’s 85 percent
and 30 percent declines against the euro and the yen from its 2002 peak to
early 2008 have rendered the current slide the biggest uninterrupted loss
of value in the currency since it became freely ﬂoated in 1971
...
S
...
S
...
The impact of such developments on the U
...
dollar and overall
global currency reserve composition could be signiﬁcant, especially as the
rally in commodities continues to unfold at the expense of the greenback,
and the euro accumulates further credibility in global markets
...
S
...
S
...
The
former is a reﬂection of increased U
...
spending on foreign products and
services and the latter a result of excessive federal spending relative to tax
revenues
...
The balance of payments records a nations’ spending and receipts of all types of ﬂows and transactions
...
An account called net errors
and omissions is used to attain the ﬁnal balance
...
Trade balance between imports and exports of goods and services—

often referred to as the trade balance
...
Income payments from inbound and outbound investments, including
net income from paid and earned interest on domestic and foreign ﬁnancial assets as well as net income from foreign direct investment
...
Net unilateral transfers of money ﬂows, which do not involve a counterclaim, such as gifts and grants
...
S
...
S
...
Since 1995, the exportsimports balance has accounted for about 90 percent of the overall current
account
...
1 compares the U
...
current account deﬁcit as a percentage
of the world GDP to that in the Eurozone, Japan, emerging Asia (EmAsia),
and oil-exporting nations
...
The rest of these nations enjoy substantial surpluses due to substantial exports revenue (in the case of oilproducing nations and emerging Asia) and due to relatively higher savings
(in the case of emerging Asia and Japan)
...
It is the net result of private and public
international investment ﬂowing in and out of the country, including foreign direct investment (ownership of lasting interest in companies, such
as at least 10 percent of total capital), portfolio investment (minority ownership of stocks or bonds), and other investments
...
The ﬁnancial account is discussed further in the
next section
...
3

United States

Eurozone

Japan

EmAsia

Oil exporters

0
...
3
−0
...
7
−1
...
7
−2
...
1 High current account deﬁcit nations are characterized by lower savings and higher interest rates
...
2 compares the U
...
international position as a percentage of
the world GDP to that of the Eurozone, Japan, emerging Asia, and oilexporting nations
...
By contrast, Japan is the biggest net lender to the world as
Japanese investors are major providers of capital to world ﬁnancial markets
...
Due to the surge in oil prices since
2002, net foreign assets in oil-producing nations have more than doubled,
propelling them to a close second behind Japan
...

A nation’s ﬁscal balance must also be taken into consideration as a
catalyst to the current account
...
S
...
Notably, the latter case has

Net Foreign Assets as Percentage of World GDP
Eurozone

Japan

EmAsia

2004

US

2003

6

Oil exporters

4
2
0
−2
−4
−6

2007

2006

2005

2002

2001

2000

1999

−8

FIGURE 7
...

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...
Imbalances, FX Reserve Diversiﬁcation, and the U
...
Dollar

165

accounted for the bulk of the ﬁnancing of the budget deﬁcit
...
Thus, while a rising budget
deﬁcit increases the ﬁnancial account surplus, it also helps to offset the
increase in the current account deﬁcit component of the balance of payments
...

U
...
CURRENT ACCOUNT DEFICIT:
OLD PROBLEM, NEW CHALLENGES
International economics theory states that depreciating currencies reduce
current account deﬁcits as they make exports cheaper to the rest of the
world while weighing on import demand via rising prices
...
For the U
...
dollar, this relationship has worked with varying
time lags
...
3 shows that out of the ﬁve major directional cycles in the
dollar index since 1971, four cycles managed to make a difference in the
current account
...
S
...
3 Is the falling dollar ﬁnally reducing the current account deﬁcit?

USD Index

50

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1982, which then posted six consecutive annual increases
...
The 47 percent increase in the dollar between
1995 and 2001 coincided with the longest increase in the current account
deﬁcit, which quadrupled to $46 billion from $11 billion or, to 4
...
5 percent of GDP
...
S
...

As for the current dollar bear market, which is in its seventh year and
losing 48 percent since its 2002 high, it is ﬁnally starting to stabilize the
widening trade gap and the current account deﬁcit
...
While the impact of the current recession has played an important role in curtailing U
...
imports, it is the role of the depreciating dollar
that helped bring about an improvement in the trade deﬁcit
...
S
...
Again, slowing U
...
economic growth and more robust economies in Europe and Asia
were effective in these U
...
trade developments, but the 18 percent decline
in the value of the dollar was paramount in increasing the affordability of
U
...
exports to the rest of the world
...
As imports outpace exports and the trade gap deteriorates, the negative trade
is reﬂected in overall growth, dampening the ﬁnal calculation of GDP
...
As economic growth falters, consumer
demand weakens and import growth slows
...
4 illustrates the relationship between the current account balance, budget balance, and interest rates since 1980
...
We note that both imbalances evolved
largely in synch, with the exception of 1992–2002, when the Clinton administration’s ﬁscal policies eliminated the budget deﬁcit via higher taxes and
lower spending, despite a rising trade deﬁcit
...
Note how
the declines in the current account deﬁcit have coincided with periods of
falling interest rates as slowing growth prompted a decline in demand for
imports
...
S
...
S
...
4 The positive correlation between U
...
budget and current account
imbalances broke during the 1990s as the former went into surplus and the latter
surged to record deﬁcits
...
In 2007–2008, this relationship is again
emerging as the deepening U
...
slowdown had eroded U
...
imports, while
the resulting fall in the dollar has boosted exports
...
As the
bear market in the currency intensiﬁed between 2003 and 2008, so did
the rally in oil prices
...
Whether it was geopolitical developments, weather factors,
or simply the general bull market in commodities behind the oil rally, oil
producers largely welcomed rising oil as a compensation for the corroding
value of the dollar, especially those whose imports are largely non-USDbased
...
S
...
Figure 7
...
S
...

Such is the reality of the oil-dollar relationship
...
5 Rising share of U
...
oil imports as a percentage of total imports is
the downside to weak dollar on trade gap
...
The only recent exception was in 2005, when a
temporary dollar rebound emerged alongside high oil prices due to accelerating oil demand from China
...
S
...
Conversely, the combination of falling oil and
the dollar would be an optimally beneﬁcial development for the U
...
trade
balance
...

While the current account deﬁcit has been around since 1981, fading
and reemerging in the ﬁnancial fabric of the U
...
economy, its presence will
take on new meaning in the evolving global marketplace
...
S
...
S
...
The current account deﬁcit may have
been around for nearly three decades, but its reaction to the shifting global
market and economic challenges is already giving rise to reverberations
not seen in at least six decades
...
Before moving on to the state of the ﬁnancing of the current account
deﬁcit, let’s shed light on the domestic imbalance: the budget deﬁcit
...
S
...
S
...
The
theory postulating that growing budget deﬁcits push up interest rates has
had a mixed record in the real world
...
Interest rates eased in the late 1990s
before recovering due to strengthening economic growth and rising inﬂationary pressures
...
The resulting erosion in the ﬁscal balance from a
surplus of 1
...
5 percent of GDP
in 2004 failed to drive up long-term interest rates
...
S
...
But when these ﬂows diminished in
2007, long-term interest rates remained pressured by traders’ expectations
of an economic downturn
...
Some economists have postulated
a direct relationship between budget deﬁcits and the dollar on the rationale that swelling budget imbalances have fueled up interest rates, causing
the dollar to gain on higher yields
...
Figure 7
...
In
1970–1976, a positive correlation between the deteriorating budget deﬁcit
and the falling dollar emerged, before the relationship broke down in the
remainder of the decade when a reduction in the deﬁcit was accompanied
by continued dollar declines
...
9 percent of GDP
...
A falling deﬁcit prevailed alongside a tumbling dollar after major economies intervened to
reverse the soaring dollar
...
The low inﬂation growth pushed

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Balances Percentage of GDP

2
...
00%

165
155
145
135
125

−2
...
00%

USD

4
...
00%

85
−8
...
00%

75
65

FIGURE 7
...

the dollar to its highest level in 15 years
...

FINANCING THE DEFICITS: THE PATH
TO UNSUSTAINABILITY?
As was mentioned earlier, a nation’s balance payment includes three major components: the current account, the ﬁnancial account, and the capital
account
...
While in the previous section we examined the
current account, this section tackles the ﬁnancial account and its position
`
vis-a-vis the current account as well as the implications for the dollar and
the U
...
economy
...
7 shows the United States’ ﬁnancial account, illustrating a net
external debt of more than $2
...
This is represented by
the excess of foreign-owned assets in the United States over U
...
-owned
assets abroad, as seen by the dotted line
...
S
...
S
...
S
...
S
...
7 U
...
-bound foreign purchases of stocks and bonds key to U
...
debtor
position
...
Soaring foreign purchases of U
...
stocks and
bonds in the mid-1980s, in contrast to negligible interest by U
...
residents
abroad, were instrumental in swaying the net investment balance into
the red
...

The main question to be raised later in this chapter is whether the United
States will continue to draw sufﬁcient capital in order to ﬁnance its current account deﬁcit
...
5 trillion in net borrowed assets, the United States has
had no difﬁculty in attracting the required capital to ﬁnance its budget and
trade deﬁcits which, combined, have risen to nearly $900 billion
...
S
...
The next section examines the key components
of these ﬂows and how their recent evolution tells us something about the
future trend
...
S
...
The former reﬂects interperiodic analysis and the latter reﬂects gross amounts held in a given year or month
...
5 trillion in assets, reﬂecting the excess of foreign-owned assets in the United
States (more than $17 trillion in 2007) over assets held abroad by U
...
residents (about $15 trillion in 2007)
...
These investment
ﬂows include both portfolio and direct investments
...
8 shows the annual difference between foreign-owned assets
in the United States and U
...
-owned assets abroad
...
S
...
While the decline means a reduction
in net capital inﬂows into the United States, it also suggests a reduction
in net foreign debt
...
S
...
S
...
8 A slowing U
...
current account deﬁcit translates into slowing net
foreign purchases of U
...
ﬁnancial assets
...
S
...
S
...
S
...
We will see
later how U
...
interest in foreign investments is increasingly playing an
important role in determining net international capital ﬂows
...
Holding other factors constant, such as equity prices and
the economy, the value of the dollar has played a key role in determining
foreign ﬂows into U
...
assets
...
9 shows that the sharp increase in
net foreign holdings in 1999 and 2000 may have been partly fueled by the
dollar’s climb to 15-year highs
...
S
...
But as the dollar began its
prolonged decline in 2002, 2003, and 2004, net foreign holdings formed a
plateau, before lifting 40 percent in 2005 on a one-time dollar rally that
year
...

U
...
STOCKS AND BONDS VIE
FOR FOREIGN MONEY
This section examines foreign inﬂows into the United States, breaking
them down by asset class
...
9 Foreign capital ﬂows were a key component to the dollar’s
1990s rally
...
S
...

Figure 7
...
S
...
S
...
The analysis applies
only to portfolio ﬂows and excludes foreign direct investment stakes
...
10 illustrates that U
...
equities were the only asset class to
have amassed an increase in net foreign buying in 2005, 2006, and 2007
...
The
question becomes whether a prolonged bear market in global stocks will
keep foreign investors on the sidelines in general, and out of U
...
markets
in particular, considering the broadening slowdown across all segments of
the U
...
economy
...
S
...
These

Net Foreign Capital Flows into United States by Asset Class
700
Treasuries and Agencies
Stocks
Corporate Bonds

600

USD Billions

500
400
300
200
100
0
2007

2006

2005

2004

2003

2002

2001

2000

1999

FIGURE 7
...
S
...

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175

U
...
Imbalances, FX Reserve Diversiﬁcation, and the U
...
Dollar

growth rates are a far cry from the 548 percent and 121 percent increase
seen in 2002 and 2003
...

The 2007 decline in net ﬂows going into corporate bonds was the ﬁrst
since 2002
...
And if
the underlying credit crisis expands into corporate balance sheets and/or
the appetite for deal making continues to dry up, then foreigners will continue to shy away from the corporate debt market, which took 60 percent
of total foreign net inﬂows in 2006
...
11 shows the changing trend of each asset class as a share of
total net inﬂows into U
...
securities
...
A recovery in Treasuries purchases was under way during 2002–2004
as bond prices rallied following the Federal Reserve’s interest rate cuts,
which took down the Fed funds rate to a four-decade low of 1 percent in
2003
...
11 Decline in foreign purchases of U
...
Treasuries and corporate
bonds has partially shifted to U
...
stocks
...
In the
current Fed cycle, U
...
Treasuries face the possibility of a similar rebound
demand to that of the 2001–2004 easing period, but the current erosion of
the U
...
dollar and the search for yield in today’s volatile equity and capital
markets may lead to a wider aversion to holding U
...
dollar-denominated
ﬁxed-income securities, especially given falling yields
...
S
...
But such interest
among foreign investors risks encountering the same fate as in 2001–2003,
when the burst of the stock market bubble dragged the equity share of
net foreign purchases from 40 percent in 2000 to 4 percent in 2004, a net
loss of $147 billion from U
...
markets
...
S
...
But the
concept of “dumb money” has also emerged as these funds seek to buy
beaten-down companies largely due to the lower price element, disregarding the negative conditions surrounding the company, the industry, and the
economy
...
S
...

Considering the increasing role of U
...
equities in attracting more than
$160 billion in net foreign purchases between 2005 and 2007, the outﬂows
may be at least just as great as those inﬂows as we approach the latter third
of the decade, due to ongoing global portfolio reallocation into emerging
markets
...
Assets in emerging market funds have doubled to $800 billion
in 2007
...

More ominously, with U
...
stock indices down having fallen more than
20 percent in summer 2008 from their 2007 highs, any added losses in U
...

stocks could jeopardize foreign demand into U
...
securities
...
S
...
Their importance is also highlighted following the credit troubles surrounding mortgage lenders Fannie Mae and Freddie Mac, whose bonds fall under the Government Sponsored Enterprise category of U
...
assets
...

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U
...
Imbalances, FX Reserve Diversiﬁcation, and the U
...
Dollar

of GSE debt fell from 44 percent of total net inﬂows in 2006 to 35 percent
in 2007
...
But to what extent will they ﬁll the void by moving to equities remains a key question
...
S
...
The previous section showed
that U
...
equities had received a growing share of foreign capital during
2003–2007 as government and corporate bonds began to ease off
...

Figure 7
...
S
...
S
...
In the ﬁscal year ending September 2007, total public debt reached
$5
...
S
...
In a matter of six years, the foreign share of total

Foreign Holdings of U
...
Treasuries as Share of Public Debt
2
...
2

41%
Percent of Total Debt

2
39%
1
...
6

35%
33%

1
...
2
29%
1

27%
25%
Sep-00

0
...
12 Foreign ownership of U
...
public debt remains on the rise
...

The top holders of U
...
treasuries continue to be Japan, China, and
the United Kingdom at $581 billion, $478 billion, and $157
...
When including Hong Kong’s Treasury holdings, China’s total Treasury stock becomes $548 billion, further closing the
gap behind Japan
...
S
...

In the case of Japan and China, these two largest holders of Treasuries are
undergoing an important evolution in their holdings
...
Figure 7
...
S
...

These opposing trends are a reﬂection of the monetary and currency policies adopted by the People’s Bank of China and the Bank of Japan
...
S
...
13 China’s accumulation of U
...
Treasuries may have peaked but
Japanese holdings remain on the decline
...
S
...
S
...
Reducing Japan’s excessive exposure to an increasingly falling U
...
dollar was also a currency
decision
...
S
...

FOREIGN DIRECT INVESTMENT
AND M&As
The preceding section focused on portfolio investment ﬂows, which involve the ownership of minority stakes in companies, without taking controlling interest or securing a lasting ownership in these assets
...
Foreign direct investment in the United States can take two
forms: (1) greenﬁeld investments involving the building of plants and companies; and (2) mergers and acquisitions (M&As) between U
...
and foreign
existing businesses
...

Figure 7
...
S
...
0
2
...
S
...
0
1
...
0
0
...
0
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980

FIGURE 7
...
S
...

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2007, with U
...
gross investments abroad totaling about $3 trillion or 22 percent of GDP
...
S
...
S
...

In order to better discern the changes in foreign direct investment in
and out of the United States, the picture must be examined from a ﬂow
perspective
...
S
...
Figure 7
...
As the dollar drifted near record lows against the euro and
13-year lows against the yen in 2007, its affordability may have further emboldened accelerating investments into U
...
companies
...
S
...
S
...
S
...
But U
...
scrutiny has quickly turned into urgent need as sovereign
wealth funds purchases of U
...
stakes jumped 153 percent to $48
...
S
...
Aside from the
seemingly cheap valuations of these companies, the falling dollar played a
major role in spurring these foreign purchases
...
S
...
A near tripling in Japanese equities and a 50 percent appreciation
in the yen against the dollar between 1985 and 1989 were behind those
spectacular investment ﬂows
...
15 Net U
...
-bound direct investment falls in the red as increased U
...

scrutiny slowly repelled foreign interest in U
...
companies
...
S
...
S
...

But a major difference from the 1980s or the 1990s is the multiplicity of investment opportunities beyond the United States and Europe
...
East Asian economies have
used their hard-earned armory of vast currency reserves to further invest mostly at home, but have yet to transform their consumption capacity into a global investment vehicle
...
S
...

HOW LONG WILL FOREIGN CAPITAL BE
AVAILABLE ON THE CHEAP?
An integral element to the sustainability of the growing U
...
current account deﬁcit has been the cost of ﬁnancing it
...
S
...
This renders the
United States a net creditor from a cost-of-capital basis, despite being a net
debtor in its overall investment position
...
Interest rates are a major driver of this
cost differential
...
S
...

Figure 7
...
S
...
S
...
S
...
Conversely, falling net interest income has prevailed during monetary policy tightening, such as in
1979–1981, 1994–1995, and 2004–2006
...
Note
that total income also includes ﬂows from foreign direct investment
...
Thanks to this privilege, which is a result of the currency’s world reserve status, the United States seems to face no difﬁculty
in extending its twin deﬁcits
...

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Current Account Deficit Financed with Positive Income
1
...
2%

16
14
12

0
...
6%

8
6

Fed Funds Percent

1
...
4%
4
0
...
0%

0
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971

FIGURE 7
...
S
...

The effective cost of foreign capital is also transmitted via exchange
rates
...
S
...
Thus, periods of dollar weakness caused by Fed easing tend to reduce the effective cost of U
...
debt
and improve the net return to U
...
investors
...
S
...
S
...
Aside from the globalization of investing and
the broadening of investment choices made by U
...
fund managers, the
falling dollar has also played a role in improving the returns of foreigncurrency-denominated assets
...
Figure 7
...
S
...
S
...
S
...
S
...
17 U
...
investors’ net purchases of foreign portfolio assets have exceeded net foreign purchases of U
...
assets since 2003
...
The chart illustrates how the intensiﬁcation of outﬂows
emerged in 2002–2003, which coincided with the beginning of the dollar
decline
...
18 breaks down U
...
net purchases of foreign stocks and
bonds, illustrating the persistence of outﬂows in both asset classes as the
search of yield reaches out internationally
...
Rising commodity prices, improved political stability, and executive accountability have all played a role in ameliorating
investor conﬁdence in international assets in both the industrialized and
developing world
...
Despite $17 trillion
in gross external debt, the U
...
continues to attract sufﬁcient foreign capital to ﬁnance $2
...
But
given the 17 percent average annual growth in net external borrowing, the
balance could reach 30 percent of GDP in less than 10 years
...
The single European currency’s share
of allocated world central bank reserves has risen from 17
...
4 percent in 2007, while that of the U
...
dollar has dropped from 71
...
9 percent
...
S
...
S
...
18 U
...
investors have increasingly turned to foreign stocks and bonds
since 2003 in search of growth and diversiﬁcation opportunities
...
S
...
S
...
(See Figure 7
...
) Despite its 80 percent increase against the
dollar from its 2000 lows, the euro has charted modest progress in its share
of the world’s currency reserves
...
7 trillion in
reserves held by the People’s Bank of China
...

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U
...
Imbalances, FX Reserve Diversiﬁcation, and the U
...
Dollar

Composition of Official Foreign Exchange Reserves
80%
USD

EUR

70%
60%
50%
40%
30%
20%
10%
0%
1999

2000

2001

2002

2003

2004

2005

2006

2007

FIGURE 7
...
S
...

CURRENCY RESERVE DIVERSIFICATION:
OPEC AND THE MIDDLE EAST
Preserving currency strength is an increasingly vital factor to the Gulf
Cooperation Council (GCC) group of nations as they plan a uniﬁed currency for 2010
...
This was seen in the late 1970s when the currencies of the European Community were pegged to an artiﬁcial currency called the ECU—the
European currency unit—in the European Exchange Rate Mechanism as a
precursor to the 1999 creation of the euro
...
The
Bank of England had to maintain the pound at the high exchange rate
of 2
...
The costs of economic disparity culminated in 1991–1992, when a struggling British economy suffering from
slowing growth and rising unemployment was further stiﬂed by the Bank
of England’s policy of keeping interest rates near Germany’s 10 percent
...
As the growth disparity escalated, the Bank of England was forced to spend over tens of billions of USD per day to support
the pound at the 2
...
On what was called “black Wednesday,”
September 16, 1992, the Bank of England threw in the towel, allowing the
pound to fall off the ERM as currency speculators spent massive amounts
selling the currency
...

In the Gulf countries, currencies pegged to the falling dollar are suffering the opposite problem of the British pound in 1991–1992
...

Prior to its 2007 decision to depeg its currency from the dollar, the Central Bank of Kuwait had faced mounting speculative pressure and was
forced to cut interest rates three times in less than two months to prevent its currency from appreciating as speculators bet that the central
bank would end its peg to the dollar
...
Allowing the currency
to be tied to the falling dollar would have stirred further inﬂationary pressures for Kuwait, not only via the declining purchasing power of the dinar,
but also through the obligation to maintain Kuwaiti interest rates in line
with those of the United States
...

In Saudi Arabia, record inﬂation rates had prevented the Saudi Arabian
Monetary Authority from mimicking the interest rate cuts of the Federal
Reserve, as has been the case over the past 20 years
...
There is also the political
element as Saudi Arabia continues to obtain concessions in arms deals with
the United States
...
S
...
As long as U
...
interest rates remain at their lows and the
dollar under pressure, portfolio losses in these central banks’ holdings will
become an issue
...
As of this writing, Qatar
and Bahrain are expected to follow suit within the next six months
...

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...
Imbalances, FX Reserve Diversiﬁcation, and the U
...
Dollar

187

Market analysts and media commentators have repeatedly wondered
at what point the dollar’s decline is considered to be at crisis level
...
S
...

While the presidents of Iran and Venezuela have made aggressive calls for
terminating the dollar pricing of OPEC’s oil, such remarks have also borne
a degree of hostility to the United States
...
2 million barrels per day, well above
the aggregate 6
...

Saudi Arabia and other Arab Gulf nations have already set up committees
assessing pricing alternatives to the dollar, such as a basket of currencies
that includes the dollar and the euro
...

Despite OPEC’s surging wealth from soaring oil, the implications of a
price pullback and continued dollar declines could be signiﬁcant
...
Assuming
a $15 decline in the price of oil and a 5 percent decline in the dollar—half
the decline of 2007—the estimated revenue would amount to nearly $170
billion
...
Rising inﬂation and falling oil receipts would not only be economically damaging to these economies, but would also prove to be politically
unsustainable as prices of everyday commodities continue to surge relative to personal incomes
...
S
...

FURTHER CURRENCY DIVERSIFICATION
IS INEVITABLE
In order to reduce their currency dependence on the falling dollar, the Gulf
nations could take the Kuwait route and tie their currencies to a basket
of international currencies (EUR, GBP, JPY, and the USD) while revaluing
the dollar portion
...
S
...
Moving toward a basket of currencies as well as reducing the dollar would be appropriate for
these nations, which are major importers of European products
...
Common solutions for alleviating the problem of surging prices have been increases in salaries and

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subsidizing food items
...

The unfolding commodity environment shows no signs of halting the
ensuing dollar damage
...
S
...

OPEC has certainly learned from its disastrous decision to raise output
in 1997, which sent prices plunging to 13-year lows at $10 per barrel as
increased supply saw little demand in the midst of the Asian economic crisis of the past decade
...

The potential for OPEC to price oil in a currency other than the dollar is at its closest point of materializing as Arab Gulf oil producers may
no longer be able to sacriﬁce the eroding purchasing power of their dollarpegged currency regimes to the beneﬁt of their mutually advantageous arrangements with Washington
...
Such an
occurrence would be a key landmark in the declining path of the U
...
dollar, thereby allowing little choice for global central bankers to further reduce their accumulation of dollars in favor of euros, sterling, and even gold
...
Last year, investment funds from the Middle East and the Far East
injected nearly half a trillion dollars worth of capital into U
...
corporations, providing them with an essential source of funding in shaky market
conditions
...
S
...
S
...
The foreign exchange currency loss from any revaluation has been a major obstacle to adjusting these increasingly unsustainable currency regimes
...

Rising purchases of U
...
corporate stakes will surely extend into the
rest of the decade, exploiting a cheap dollar and fallen prices
...
S
...
As a result, any gain in protectionist momentum from the presidential hopefuls will easily deter SWFs

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...
Imbalances, FX Reserve Diversiﬁcation, and the U
...
Dollar

189

from U
...
borders
...
SWFs from Kuwait and Qatar have already started diversifying into
Japanese, East Asian, and European investment opportunities
...
S
...
Any further escalation in protectionist rhetoric from
the new administration will not only deﬂect vital doses of capital from U
...

companies, but also further weaken an already unstable ﬂow of foreign ﬁnancing of the $800 billion current account deﬁcit
...

THE VIEW AHEAD
These are the realities of the new global economy
...
S
...
The advent of the euro as an increasingly
reliable and robust medium of exchange run by a highly respected central bank is posing the ﬁrst real threat to the dollar’s global reserve status
since World War II
...
S
...

The underlying assumption that the United States will continue borrowing cheap capital to ﬁnance its deﬁcits is facing stiff resistance
...

The six-year decline of the dollar has ﬁnally begun shrinking the trade
gap by making U
...
exports more affordable abroad
...
Unlike the past
three recessions of the 1980s, 1990–1991, and 2000–2001, which prevailed
during a period of a strong dollar, the current economic slowdown has
presented exceptional challenges due to the inﬂationary consequences of
the falling currency
...
S
...
These woes could be exacerbated
in the event of renewed erosion in the dollar
...
Besides the oil-driven element of a weak
dollar, this time the greenback is in the midst of a prolonged down cycle,
dogged by the simultaneous existence of credible alternatives for currencies and yield
...

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CHAPTER 8

Commodities
Supercycles and
Currencies

he commodities price rally at the turn of the decade has helped redraw the ﬁnancial market landscape and broaden investment and
speculative opportunities for institutions, money managers, and individual investors
...
Commodities have branched out into a multifaceted
asset class, enabling investors to exploit the growth opportunities in just
about every component of the production process of the global economy
...
S
...
S
...
The burst of dot-com bubble
in U
...
equities throughout 2000–2002 and the resulting Fed easing policy
slashing interest rates to 45-year lows dealt a severe blow to the dollar’s
yield foundation relative to other currencies
...
” A swelling trade deﬁcit, an increasingly lax ﬁscal policy, and an unpopular war in Iraq all drew parallels with the economic and foreign policy
realities of the early 1970s
...
A powerful conﬂuence of supply and demand dynamics easing
the way for the economic advancement of key emerging nations, as well
as the surfacing of new rules in international economics and ﬁnancial markets, helped create the broadest and deepest rally in commodities since the

T

191

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late 1970s
...

Increased integration of commodities into the investment plans of institutions and individuals has also helped boost price appreciation of most
commodities
...
The creation of new investment vehicles such as exchange-traded funds (ETFs) has facilitated individual investors’ shifts into commodities, thereby enhancing liquidity and
information ﬂow
...
1 highlights the extent of the rise in the various commodity
groups since January 2003, illustrating that metals were the fastest-gaining
group into early 2007, followed by energy and food items
...

As the emerging economies of Asia, the Gulf, and Latin America further participate in the global economy and fortify their foreign exchange reserves via stronger export revenues, their spending powers shift toward expanding infrastructure and feeding their growing populations
...
03 = 100)
370
Energy
Food
Agricultural Raw Materials
Metals
USD

320
270
220
170
120
70

Jan-08

Sep-07

May-07

Jan-07

Sep-06

May-06

Jan-06

Sep-05

May-05

Jan-05

Sep-04

May-04

Jan-04

Sep-03

May-03

Jan-03

FIGURE 8
...

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193

demand for copper and aluminum for building and wiring cities; corn and
soy for nourishing a growing population and dependable livestocks; oil and
gas for transporting people and generating power for factories; and ﬁnally,
surging demands for all of these as the self-feeding mechanism persists, regardless of whether the industrialized economies are slowing or growing
...
Investors poured about $142 billion into commodities funds in 2007 from less
than $10 billion in 1998
...
Speculation has also been instrumental in adding to
the liquidity of these funds, permitting short-term traders to push up prices
to record highs, compounding the favorable supply and demand factors
among producers, suppliers, and consumers
...
Table 8
...
Crude oil and copper started their ascendance
as early as 2001, before being joined by the rest of commodity groups in
2004–2005
...
Figure 8
...

The price decline in beverages and beef was behind the shorter price boom
...
The
current supply and demand factors underpinning the various commodity
groups are likely to prolong the duration of the prevailing rallies
...
While major price rallies
emerged at the end of relatively long periods of economic expansion, the
current boom started earlier in the cycle of the global economic and industrial expansion
...

The 2000 rally in commodities was another example of surging prices at

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TABLE 8
...
1
104
...
0
212
...
9
30
...
2
124
...
9
116
...
9
−25
...
2

Jan-05

54
...
0
41
...
0
84
...
0
39
...
0
42
...
0
50
...
0
28
...
2

56
...

Number of Large Commodity Booms
25

20

15

10

5

0
2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

FIGURE 8
...

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Commodities Supercycles and Currencies

the end of major economic expansions
...
S
...
In the current price boom, copper and oil
prices started rallying in 2001, but the acceleration in those rallies wasn’t
stepped up until 2004–2005 when the world economy had fully emerged
from the 2001–2002 economic downturn
...
Whether it is the price impact on oil and food from
the increased production of biofuels, or the depreciation of the dollar and
falling real interest rates, commodities have beneﬁted in ways not seen
before
...
3 illustrates the annual price change in the U
...
producer price
index for metals and farm products since 1914, and for all commodities
together since 1927
...
3 Despite their recent ascent, U
...
producer prices index remain lower
than in previous historical advances, implying that current price strength is greater
in real terms
...
0 percent as of July 2008
...

DISSECTING COMMODITY CLASSES
In order to better understand the current commodities cycle, it is essential
to break price trends down into the various commodities classes and examine the supply and demand forces underpinning them individually
...

Figure 8
...
The chart measures the ﬁve commodities and the CRB
over four different periods: January 2000 through May 2008, January 2002
through May 2008, January 2005 through May 2008, and January 2007
through May 2008
...
The rationale
Oil Dominates Commodities Race
OIL
CORN

GOLD
CRB

SOY
COPPER

Price Change (Percent)

500

400

300

200

100

0
Jan
...
2002 to
May 2008

Jan
...
2007 to
May 2008

FIGURE 8
...

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Commodities Supercycles and Currencies

of these price developments suggests that the current commodities cycle
began on the heels of the two commodities used most widely in construction, power generation, and transportation
...
Despite the accelerating slowdown in the U
...
economy,
global oil demand is anticipated to post a small increase, rather than a decrease, as was the case in past periods of slowdown in the United States
...
The
economic decoupling in select emerging economies is playing a signiﬁcant
role in ﬁlling the slack in demand for oil and other commodities, such as
agriculture, metals, and other fuels
...

Just as gold is powered by speculators, so is crude oil
...
5 shows
the volatile activity among speculators’ interest in oil
...
But as will be seen later,
the fundamental forces prolonging the fuel’s rise have become more cyclical (related to economic growth) and structural (supply and technology) in
nature and therefore more durable than those resulting from speculators
...
5 Speculators have helped fuel oil run
...
Despite
the risk of projected slowdown in global oil demand, the underlying supply realities continue to provide vital support for prices going forward
...

Unlike in the 1970s, when most oil ﬁelds were located near consumption centers, the concentration of most current reserves is located in countries that are far away from large consuming markets, thus involving escalating shipping costs and sometimes delays
...
U
...
-based international companies have seen their development costs increase ﬁvefold to
about $22 per barrel between 1995 and 2007
...
Russia, Mexico, and the North Sea have all struggled with faltering production
...
In fact, Russia may have its ﬁrst
output decline since 1998 due to eroding production in western Siberia
...
Russian oil
executives estimate that over $1 trillion a year will be needed to invest
in exploring new ﬁelds in order for current production levels of 9 to 9
...
This may augur
badly for future supplies as most ofﬁcial estimates place Russia as third top
contributor to the 2
...

With the possibility that acreage expansions devoted for biofuels are
likely to be untenable due to surging food prices, a decrease in biofuels and
Russian supply may leave Brazil, Canada, and central Asia as the remaining
non-OPEC sources of oil
...
9 million barrels per day,
Mexico is the world’s sixth-largest oil producer and provides 8 percent of
U
...
supplies
...
Its
Cantarell ﬁeld in the Gulf of Mexico is the world’s second-largest so-called
super-giant ﬁeld but its output has been falling at an annual rate of 15 percent since production peaked in 2004
...
9 millions barrels per day in March 2008 from its peak

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of 3
...
Underinvestment and misallocation
of capital have rendered Mexico’s drilling equipment mostly obsolete, leaving the country with less than 15 billion barrels in proven reserves in 2008
...
Larger oil reserves are believed to be located in the deep waters of the Gulf of Mexico, as far as 10,000 feet below surface
...
As a result, the
laws reduce any incentive for oil companies to invest hundreds of millions
of dollars to share their know-how with the national oil company and obtain proven reserves on their books
...
S
...
The 20 percent decline in the U
...
dollar during
2006–2007 has also signaled the red ﬂag amid OPEC nations, raising the
possibility of further currency declines in the event of prolonged deterioration in the U
...
credit crunch and on the macroeconomic front
...
Ten years later, OPEC’s rising economies have enabled it to maintain
output even in the face of a slowing global economy in the event that conditions take a turn to the worse
...

Gold’s Multifaceted Shine
The price escalation in metals has broken away from previous trends,
prominently shrugging off the 2007–2008 credit crunch and economic slowdown in the United States, Canada, Europe, and Japan
...
China alone consumes 35 percent of world iron ore versus 8 percent
for the United States
...
China’s estimated net electricity use
between 2003 and 2030 stands at a rate of 4
...
6 percent

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for India, 3
...
0 percent for the Middle East
...
6 percent, 1
...
2 percent for the United States,
Canada, and OECD Europe
...
6 shows gold’s performance against
silver, oil, and the Commodity Research Bureau’s commodities index from
January 2001
...
Jewelry makes up about 68 percent of the world’s
gold demand and India is at the top of that list
...
Together they account for 40 percent of global
demand
...
Investments and speculation make up
about 11 percent of demand for gold
...
These funds allow institutions, hedge funds, pension funds, and
household investors to snap up gold at face values that are as small as a
tenth of the bullion price
...
2001 = 100)
500
Gold
Silver
CRB
Oil

450
400
350
300
250
200
150
100
50

1/5/2008

9/5/2007

5/5/2007

1/5/2007

9/5/2006

5/5/2006

1/5/2006

9/5/2005

5/5/2005

1/5/2005

9/5/2004

5/5/2004

1/5/2004

9/5/2003

5/5/2003

1/5/2003

9/5/2002

5/5/2002

1/5/2002

9/5/2001

5/5/2001

1/5/2001

FIGURE 8
...

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Commodities Supercycles and Currencies

rendering it a mainstream asset class
...
Gold ETFs now rank as the world’s seventh-largest holder
of physical bullion, surpassed by the United States, Germany, the International Monetary Fund, France, Italy, and Switzerland
...
3 billion
...
Figure 8
...
These positions are known as
the commitments of traders as each contract represents an outstanding
position to buy or sell
...

The supply side of gold has also contributed to the run-up in prices
...
The world’s top gold producer has seen output plummet to
70-year lows
...
As the upward price trend accelerated markedly between 2005 and

Gold versus Speculative Long/Short Positions
250

1100
Net Longs/Shorts
Gold

200

Gold $/Ounce

900

150

800
100
700
50
600
0
500

Net Long/Short (Thousands)

1000

–50

400
300

–100

200

–150
08/15/08

05/01/07

07/25/06

10/18/05

01/11/05

04/06/04

07/01/03

09/24/02

12/18/2001

3/13/2001

6/6/2000

8/31/1999

11/24/1998

2/17/1998

5/13/1997

8/6/1996

10/31/1995

1/24/1995

4/19/1994

7/13/1993

10/6/1992

FIGURE 8
...

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2008, companies closed their forward and options hedging positions so as
to maximize the value of their outstanding positions
...

Copper Is Preciously Vital
While the role of gold as a hedge against inﬂation and falling paper currencies gives it its prolonged allure, copper remains the most sought metal
in the broader phases of manufacturing, construction, and electrical development
...
But given China’s steady role as the world’s largest
copper consumer since 2002, its appetite for the metal has overshadowed
any signs of a slowdown in the industrialized world
...
2 pounds, well below the 30 to 40 pounds per
capita for developed countries
...

As in the case with gold, copper is also supported by an array of supplyrelated dynamics such as power shortages, strikes, and underinvestment
...

Figure 8
...
2003 = 100)

600

Gold
Copper

500
400
300
200
100
0

11/15/2007

2/7/2008

6/11/2007

8/29/2007

3/19/2007

12/28/2006

7/20/2006

10/9/2006

2/8/2006

5/2/2006

11/17/2005

8/31/2005

3/21/2005

6/13/2005

10/11/2004

12/30/2004

7/22/2004

2/10/2004

4/30/2004

9/2/2003

11/19/2003

6/13/2003

1/2/2003

3/21/2003

FIGURE 8
...

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demand
...

Food and Grains Feed on Global Appetite
The durability of the current commodity supercycle is rendered especially
potent by the rise in grains, crops, and food
...
The main factors underpinning
the rise in food are the following
...
Consequently, large supermarket
chains and discount stores have increasingly catered to consumers from
this emerging socioeconomic class, offering a wider range of imported
foods
...
Figure 8
...
This compares to 10 percent, 14 percent, and 21
percent for the United Kingdom, the United States, and the Eurozone
...
9 Food spending is a higher proportion of overall spending in Asia
than in Europe and the United States
...
10)
...
Asian meat consumption
has risen 40 percent over the past 15 years, thereby boosting demand for
wheat and corn for feedstocks
...
S
...
President George W
...
As a result, U
...

corn production nearly doubled to 4 billion bushels in two years, driving
prices up by 50 percent to $6 a bushel within one year
...

As corn is shifted away from foods and syrups to biofuels, neither
hunger nor escalating food prices will be contained
...
S
...
Thus, while U
...
import tariffs on ethanol
are designed to protect local growers of sugarcane, such protection raises
the burden on local consumers
...
10 Surging global food consumption will challenge limited supplies
...
The price action has since prompted many
back to soy
...
Figure 8
...

The speculative element is also present in grains
...
12 shows
how speculators have responded to the U
...
administration’s biofuels
Corn, Wheat, Soy Prices (Dec
...
11 Corn battles it out with soy
...
12 Corn speculators maneuver around farmers’ planting trends
...
As farmers rushed
toward corn, soybeans lost in favor and so did their price
...

Rising Fuel Prices Higher oil prices have driven up the cost of agriculture inputs, such as tractors and other farming equipment, while rising
natural gas prices have boosted the price of fertilizers
...

Nitrogen fertilizers, used in enhancing farm productivity, are largely
dependent on the price of natural gas
...
Farmers in the developing world face the double
whammy of soaring fertilizer prices from abroad as well as higher prices
of grains used for animal feed
...
The Baltic Dry Index measuring freight
rates for most commodities quadrupled in value between 2005 and 2007
...
S
...

Elevated Dairy Products Rising dairy prices have been a result of the
emerging middle class frequenting the surge of supermarket chains, where
imported cheese and ice cream have become popular dairy products
...
As a result, milk prices are hiked in the export
market
...

The shift of corn toward biofuel production and away from cattle feed
has also contributed to the elevated price of dairy cows and dairy products
...
The resulting impact on
New Zealand’s currency has been noticeable
...
Barriers on exports were imposed
as a way to contain food prices domestically and preserve self-sufﬁciency
...
In the case of rice, supplies fell to
25-year lows, prompting India to ban exports of non-basmati rice
...
Governments in
Argentina, Kazakhstan, India, and Vietnam have taxed imports heavily to
keep markets well supplied
...

Weather Droughts and ﬂoods have impacted agricultural production by
eroding crops, thus driving up crop prices
...
In the United Kingdom and northern Europe, ﬂoods retarded agriculture production, as did the drought in
southern Europe
...
S
...
Figure 8
...
S
...

Dollar Correlation with Various Commodities
0
...
20

1990–1999

2000–2007

0
...
00
−0
...
20
−0
...
40
−0
...
60
Gold

Oil

Nonfuel

Metal

Food

FIGURE 8
...
S
...

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The geopolitical events of the 1980s, such as the Soviet invasion
of Afghanistan—which triggered a $320 jump in gold in less than one
month—were accompanied by equally sharp moves in the currency
...
The dollar soared 94 percent in
the ﬁrst half of the decade, before the coordinated interventions of the
Plaza Accord helped drive it back down by 50 percent into the rest of
the decade
...
S
...
In 1999, the dollar index surged
to 10-year highs, coinciding with 14-year lows for oil at $12 per barrel and 20-year lows for gold at $253 per ounce
...
Nonetheless, the price developments in the ﬁrst ﬁve
months of 2008 have shown USD correlations between gold and oil to have
resurged back into the range of −0
...

DEVELOPING WORLD TO MAINTAIN
RIPE OUTLOOK FOR FOOD AND GRAINS
Unlike in the past when food, feedstocks, and ﬁbers were the dominant
uses of grains, fuel is now becoming a major end product for grains, hence
the surging demand and soaring prices for the crop
...

In 2007, U
...
farmers planted more corn than in any other year since
World War II after U
...
legislation encouraged the increasing use of corn
for biofuels to reduce dependence on foreign oil
...
U
...
ethanol production has also more than doubled,
reaching over 6 billion in 2007 from less than 3 billion, with further expansion expected to push production above 12 billion gallons by 2010
...
S
...
7 billion gallons in 2007
...
If ethanol production is to accelerate at such a pace mainly

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from corn production, the question becomes how to speed up corn production at such a pace for so long?
The shift to corn by U
...
farmers has reduced the production of soybeans, the price of which has soared to new record highs but which remains cheaper to grow than corn
...
S
...
To produce
the necessary amount of ethanol, the United States may need to reduce the
54 cents per gallon tariff imposed on imported ethanol
...
S
...

Aside from the classic forces of supply and demand, agricultural
prices have been boosted by demand from new end-importer clients such
as China and developing East Asia
...
China’s
per capita annual meat consumption has more than doubled since 1980
to 242
...
Figure 8
...
As
the demand for meat surges, so will the demand for feedstocks for cattle
and poultry
...
The grains
implications of China’s changing beefy diets are signiﬁcant
...
5

3

2
...
5
2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1985

1983

1981

FIGURE 8
...

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At odds with these demand factors in China are the supply constraints
of arable land (Figure 8
...
As China’s population becomes more urban
and the rural areas are steadily converted to industrial and residential use,
the future outlook for agriculture appears highly uncertain
...
Aside from cracking down on unauthorized land expansion
projects, Chinese authorities have not reached any solutions for the eroding land problem
...

As long as these demand and supply constraints continue to lift agricultural commodities higher, export tariffs are expected to remain a long-term
reality, further driving up prices
...
Such restrictions on the global ﬂow of rice will be one of the many
underpinnings for higher commodity prices
...
15 China’s rising urbanism threatens arable land
...
The Australian dollar, New
Zealand dollar, Canadian dollar, and Brazilian real are the principal commodity currencies traded in the freely functioning global currency markets
...
90 to 3
...
S
...

Brazilian Real Brazil’s currency has reaped the beneﬁts from its position as the world’s largest exporter of ethanol and soybeans at a time
when these two items loom large at the top of commodity league
...
Brazil’s vast sugarcane ﬁelds make its sugarcane-based
ethanol cheaper and more energy efﬁcient than the corn-based ethanol
produced in the United States
...
Brazil competes
with the United States for the number one slot in soybean exports and was
number one in 2008, exporting 25 million tons of soy, or 39 percent of the
world’s total
...

New Zealand Dollar New Zealand is the world’s leading maker of dairy
products and the fourth-largest milk producer
...
The resulting impact on its currency has been noticeable
...
16 shows the predominantly positive relationship between milk
prices and the New Zealand dollar
...
Australia produced an
estimated 15 million tons in the 2008 season, but the record droughts of
2006–2007 may push the country to speed up its crop production and possibly displace Canada in second position
...
Considering the breadth of the latest

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NZD/USD versus Milk Prices
23

0
...
75

21

0
...
6

15

0
...
65

0
...
45
11
9
Jan-97

0
...
35
Sep-98

May-00

Jan-02

Sep-03

May-05

Jan-07

FIGURE 8
...

commodities rally and the fairly robust relationship between grains and
oil, the loonie’s uptrend is expected to be sustained despite downside risks
from its southern neighbor
...
17 illustrates the performance of the aussie, real, loonie, and
kiwi over the four different periods: January 2000 to May 2008, January
2002 to May 2008, January 2005 to May 2008, and January 2007 to May
2008
...
e
...
But note how the performance changed in the more recent
measurement periods when the strengthening rally fed on a 152 percent
and 106 percent increase in soy and a 189 percent and 60 percent increase
in corn from January 2005 to May 2008 and from January 2007 to May 2008
...

Figure 8
...
Between
2006 and May 2008, prices of soy and corn rose more than 130 percent,

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Food/Grain-Dependent Currencies' Return

Percent

AUD

BRL

CAD

NZD

100
90
80
70
60
50
40
30
20
10
0
Jan
...
2002 to
May 2008

Jan
...
2007 to
May 2008

FIGURE 8
...

Growth in Food/Grain Currencies Since 2005
CAD

BRL

AUD

NZD

50
Change Percent

40
30
20
10
0
–10
–20
4/6/2008

1/27/2008

11/18/2007

9/9/2007

7/1/2007

4/22/2007

2/11/2007

12/3/2006

9/24/2006

7/16/2006

5/7/2006

2/26/2006

12/18/2005

10/9/2005

7/31/2005

5/22/2005

3/13/2005

1/2/2005

FIGURE 8
...

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while wheat soared more than 215 percent over the same period
...
Between January 2002 and April 2008, Brazil’s
Bovespa equity benchmark index rose 440 percent, while gaining 106 percent from January 2007 to April 2008
...

Finally, one currency that may be worth considering as a viable commodity play in the food business is the Polish zloty
...
5 percent
...
The zloty’s future outlook may be
underpinned by Poland’s intention to join the European Monetary Union,
which requires the country to meet strict ﬁscal and inﬂation control criteria
...

ENERGY EFFICIENCY NOT ENOUGH TO
HALT HIGH OIL
Although the surge in oil prices has been increasingly compared to the dotcom bubble and other demand-oriented bubbles, the solidity of the current
rally is characterized by supply-speciﬁc dynamics whose existence feeds
price escalation despite any demand slowdown in the industrialized world
...
Chinese appetite has been instrumental in ﬁlling the slack during the economic slowdown encountered in the United States and Europe,
taking over 9 percent of the world’s consumption
...
This means China’s oil imports will jump ﬁvefold from
its current 3
...

The supply realities have also shaped the oil price environment
...
2 million barrels in 2008, supply forecasts were trimmed to 815,000 barrels per

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day
...
3 million barrels per
day, with non-OPEC supply increasing by about 800,000 barrels per day
...

This raises the question as to how OPEC output will ﬁll the gap, when
even Saudi Arabia has difﬁculties surpassing its maximum capacity
...
Indeed, unlike in the previous years of high oil such
as 1999, 2003, and 2004, when speculation was the only main explanation
OPEC could offer as a reason for high oil, today’s rising price environment
is largely shaped by tangible factors that are likely to endure for quite some
time
...
S
...
But prices would quickly rebound
at the mere mention of the U
...
credit crunch and the falling dollar being
the cause of prolonged oil strength
...
S
...

Even if OPEC were able to increase output signiﬁcantly, the cartel
will grow cautious due to increased energy efﬁciency in the industrialized
world
...
S
...
As the popularity of fuel-efﬁcient cars increases and
the use of ethanol enters the mainstream, the need for new but environmentally controversial drilling will abate
...
Rising oil prices and increased efﬁciency have prompted the
IEA to cut its forecast of overall U
...
fuel demand, predicting it will grow
from about 20
...
8 million barrels per
day in 2030, rather than to 26
...
But as we have seen
throughout this chapter, any future slowdown in U
...
demand for oil or
for any other commodity will likely be offset by demand from fast-growing
economies in Asia
...
Of the oil ﬁelds discovered since the late 1970s,
none has produced more than 1 million barrels per day
...
One must also not assume that
OPEC will open the ﬂood gates of supply at the ﬁrst sign of accelerating

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demand from China or India
...
5 million barrels per day projected output for 2009
...
’”

Currency Plays in Energy
As in the previous section, only currencies that are freely in the global foreign exchange market are listed, while currencies that are in a managed
ﬂoat or set by a trading band are not included
...
The petroleum sector contributes more than one-half of
total export revenue, while crude oil, natural gas, and reﬁned petroleum
products account for two-thirds of total exports
...
Surging oil prices pushed up Norway’s merchandise trade surplus to a record
US$61
...

While the similarities between the Norwegian Krone and the Canadian
dollar make it relatively difﬁcult to pick which currency is most apt to beneﬁt from rising oil, one large difference is the nations’ export market
...
As we see in the following section on the Canadian dollar,
80 percent of Canada’s exports are destined for the United States, thereby
rendering the loonie vulnerable to any downdraft from that country, as was
already manifest in 2008
...
Canada sends 80 percent of its total exports to the United States, and over 90 percent of its oil is sold to that
country
...
27 million barrels per day as of 2008
...
About 97 percent of Canada’s proven reserves are in the form
of bitumen oil, which account for 47 percent of total production
...
In fact,
the environmental leaning of the next U
...
president after the 2008 elections may help shape the fate of future U
...
projects and gear future capital
to Canada
...
As of May 2008, half of Russia’s main stock market index consists of
energy and oil companies
...
S
...
Oil’s 479 percent increase from January 2002 to May 2008 bolstered
Russia’s external trade position but also spurred inﬂation, which surpassed
14 percent in the second quarter of 2008
...
Although the
central bank intends to add some uncertainty to speculators’ expectations
of further ruble appreciation by intervening less in the currency markets,
persistent increases in energy and grains prices will further bolster Russia’s
external trade position and underpin its currency
...

Mexican Peso Mexico is the world’s sixth-largest exporter of crude oil
and the provider of 14 percent of U
...
oil needs
...
Mexico’s economy
has also been boosted by the maquiladora industry (importing materials
and equipment for manufacturing and then reexporting products for U
...

companies) as well as beneﬁted by agriculture
...
More than 80 percent of the country’s exports go to the
United States
...
S
...

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The performance chart in Figure 8
...
Interestingly, the Mexican peso ended lower against the USD during
the periods spanning January 2000 to May 2008 and January 2002 to May
2008, during which oil surged 382 percent and 479 percent respectively
...

Brazilian Real Brazil is known as home to the world’s largest sugarcane ﬁelds and the cleanest and most energy efﬁcient type of ethanol, but
it may also become a major player on the crude oil scene
...
Full exploitation
of these reserves could lift Brazil to the top-ﬁve list of oil producers from
its current 19th position
...
Separately, Brazil’s partially state-owned oil company Petrobras has become the third-largest publicly traded company in
the Americas as of April 2008, with a market value of US$295
...

The company has even surpassed Microsoft, which has a market value of
US$274 billion
...
2000 to
May 2008

Jan
...
2005 to
May 2008

Jan
...
19 Norwegian krone proves its superiority as an oil currency while
Mexican peso reﬂects the country’s eroding oil output
...
20 illustrates the performance of the four oil-dependent currencies against the U
...
dollar between January 2002 and May 2008
...

COPPER AND GOLD TO SHINE ON
LONG-TERM FUNDAMENTALS
As in the case of energy and grains, supply considerations have supported
and are likely to continue to support copper and other metals into at least
the rest of the decade, due to the following factors:

r Underinvestment in the mining sector, resulting from the price slump
r
r
r
r

of the 1990s, hampered the creation of large capacity-enhancing
projects
...

Mining companies are experiencing continuous strikes and mounting
contract negotiations by mine workers demanding a higher share of
windfall proﬁts from surging metals prices
...

Environmental restrictions add to existing delays and lag time
...
20 Norwegian krone and Canadian dollar performance battle it out,
leaving peso and ruble behind
...
The emergence of Australia as a
powerful copper producer has been instrumental in elevating the aussie
among the most heavily traded currencies in the foreign exchange market
today
...

Chilean Peso Chile is the world’s largest exporter of copper, which
makes up nearly 55 percent of its total exports, with overall mining accounting for 8 percent of the nation’s GDP
...
The demand equation is also bolstered by China’s surging copper
demand, aimed at rebuilding its faltering power grid
...

The 358 percent advance in copper between January 2000 and May
2008 is the second-biggest increase in a single commodity class, second
only to the 382 percent increase in oil
...
4 percent
of GDP
...

Australia is the world’s fourth-largest exporter of copper, and a leading
producer of gold, iron ore, and aluminum
...
The 358 percent increase in copper from January 2000 to May
2008 and the near tripling in wheat have helped the economy avoid the
strains of a soaring aussie, despite its surge to 24-year highs against the
U
...
dollar
...
25 percent in spring 2008
...
S
...
The share of the AUD/USD pair’s trading volume as a
percentage of daily reported turnover rose to 6 percent in 2007, from 5 percent and 4 percent in 2004 and 2001 respectively
...
4 percent in 1998 to

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3
...
2 percent, and 4
...

Peruvian New Sol Peru’s position as the world’s second-largest exporter of copper has been a boon to the Peruvian new sol and the overall
economy, as the metal makes up 25 percent of total merchandise exports
...
Having a tenth of its exports sold to China’s demand machine helps
the economy stave off any potential downturn in demand from the United
States, which accounts for 24 percent of total exports
...

Despite the intensity of supply-side constraints emerging from power outages, labor unrest, and environmental opposition to building new mines,
metals analysts have propped their price forecast for copper to increase by
nearly 20 percent during the course of 2010–2020, thereby further underpinning the supercycle in the metal
...
Power shortages, labor unrest, and violence-related
disruptions have led to a 73 percent decline in gold production from 1970
to 2007
...
As a result, the rand fell 10 percent in 2007 despite gold’s 100 percent
increase over the year
...
This is the opposite case from
Australia, whose developed mining companies have the capacity to step up
copper production and sell the high-priced metal in the export market
...
1 percent in the ﬁrst quarter of 2008 from 5
...
Mining output tumbled 22
...
As long as gold prices remain on their ascent and South African mines lose ground on high margin
opportunities, the rand is likely to sustain its downward path
...
Such exposure to the struggling U
...
economy and the
lack of exposure to China’s anticipated demand surge places South African

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trade at relative disadvantage to Australia, Chile, and Peru all of which
derive a far greater share of exports from China
...
21 shows the aussie’s performance against the U
...
dollar relative to the rest of the currencies whose nations are large producers of
copper and iron ore
...
When copper prices surged 84 percent
between October 2007 and May 2008, the aussie rose 7 percent against the
USD, versus 11 percent for Peru’s new sol
...
The ﬁgure also shows that the once-robust relationship between the South African rand and gold has largely dwindled as
a result of South Africa’s plummeting gold production
...

Figure 8
...

Currency traders are no longer impressed with South Africa’s position as
world’s biggest gold producer, especially as power shortages eroded overall economic output and employment, beyond just the precious metal
...
2000 to
May 2008

Jan
...
2005 to
May 2008

Jan
...
21 Aussie leads metal-dependent currencies, while Chilean peso follows closely
...
22 South Africa’s falling gold production takes the shine oﬀ the rand
...
South Africa’s leading position as the world’s
top gold producer may not matter to the markets as much as the gradual
diminishing of that position to producing and exporting nations of gold and
copper
...
The latest commodity boom
has repeatedly been dismissed as a speculative bubble in the making as
pundits make ﬂawed comparisons to previous asset bubbles and manias
...
Unlike the dot-com bubble of the late
1990s, which was founded on a combination of misperceptions of stock valuations, inexistent corporate proﬁts, outlandish price targets by analysts,
and unrealistic expectations by individual investors, the current price cycle
in most commodities classes reﬂects real demand and supply requirements

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for actual products that are instrumental in the nourishment of growing
populations, building infrastructures, and technologies
...

The growing use of biofuels and increased demand from China and India ties into the growing demand for corn and other grains, thus bolstering the foundation of higher prices for grains and agricultural products
...
On the metals
front, gold will likely preserve its secular rally as rising world inﬂation challenges the role of ﬁat money
...

Further underpinning these powerful supply and demand forces is the
thirst of investors
...
In
the ﬁrst 10 weeks of 2008, demand for commodity funds grew by more than
$55 billion, or nearly $1 billion a day
...

The currency implications of these compelling price trends are signiﬁcant
...
The Chilean peso and Peruvian new sol have yet to draw
the awareness of the average individual investor, but further amelioration
in macroeconomic and market dynamics will increase the luster of these
two currencies, broadening the choice of investment alternatives in the
commodities world
...

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CHAPTER 9

Selected Topics
in Foreign
Exchange

aving tackled the bond, equity, and commodity market nuances of
foreign exchange markets, we now turn to a compartmentalized approach in the book, revisiting previous themes as well as opening
new ones
...

In Chapter 6 we focused on the relationship between the U
...
yield
curve, the economy, the stock market, and the U
...
dollar
...
In this chapter, the tables are reversed as we explore the
use of steepening yield curves in order to predict interest rate hikes
...
Commodities and equities are also revisited, but this time
the focus is placed on commodities as a whole rather than on gold in order to better highlight the relationship between monetary and hard assets
...
S
...

H

REVISITING YIELD CURVES
In Chapter 6, we analyzed the relationship between yield curve inversions
and interest rate cuts, highlighting how this link can be used to predict
225

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future changes in interest rates and the implications for currency and equity markets
...
S
...

Recall that Chapter 6 focused on illustrating the yield curve’s effectiveness in predicting interest rate cuts by the Federal Reserve, when other indicators have pointed otherwise
...
1 starts off with summer of 1998
when the yield curve moved from normal to ﬂat, suggesting the possibility
of interest rate cuts ahead
...
The yield curve signal was a
valuable indicator especially considering that macroeconomic ﬁgures were
pointing to persistent strength; non-farm payrolls stood above their historical average; and GDP growth was above the Fed’s trend growth rate of
2
...

The yield curve again proved effective when it signaled the peak of
the 1990s tech bubble with a two-month lead, which was later followed
by a three-year bear market and a recession in 2001–2002
...
5 percent to 1 percent
...
As in 1998, the inversion was accompanied by contradictory market signals from recordbreaking highs in stocks and escalating liquidity
...
Once
again, the Fed was forced to slash interest rates, less than two months

Yield Curve Inversions and the USD
130

10-2 Spread
USD

120

2
110

1
...
5

03/26/99

80

10/23/98

0
06/01/98

90

01/02/98

0
...
5

FIGURE 9
...
S
...

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Selected Topics in Foreign Exchange

after it had warned of inﬂationary pressures
...
25 percent to 2 percent in a matter of eight months
...

Yield Curves Patterns Ahead of Fed Hikes
While the preceding dynamics explained the yield curve’s effectiveness in
predicting interest rate cuts, how could the yield curve be used in predicting interest rate hikes? Recall that the period of time elapsed between
the beginning of yield curve inversions and the beginning of the Fed cuts
ranged from as little as 3 months during the June–July 1998 inversion to
19 months during the January 2006–June 2007 inversion
...

So can we predict interest rate hikes with the opposite of yield curve
inversions—that is, yield curve normalization? Figure 9
...
The chart
focuses on the past four tightening cycles, namely February 1994 through
February 1995; March 1997; June 1999 through May 2000; and June 2004
through June 2006, with each of the cycles marked by a rectangular box
in the chart
...
Peaking
yield spreads are explained by a reduction in the extent to which 10-year
yields are gaining over 2-year yields, which is often reﬂected in a faster
increase in 2-year yields
...
S
...
2 Peaking formations in U
...
10-2 yield spread have often preceded
periods of Fed rate hikes as short-term yields rose relative to longer-term yields
...
As this takes place, rising 2year yields begin to narrow the difference between 10- and 2-year yields
and the preceding increase in the spread begins to lose steam—hence
the peak
...
Once the Fed
concludes its easing cycle and makes the transition toward a policy of
steady interest rates, the post-easing decrease in 2-year yields begins to
wane, followed by a gradual turnaround that narrows the difference with
10-year yields
...
As 2-year yields
gain further, the peaking 10-2 yield spread turns gradually lower, at which
point is the timing of the interest rate hike
...
Determining the peak of the
10-2 yield spread may prove challenging in its use to predict the ﬁrst rate
hike
...

Can USD/JPY Help Anticipate Rate Hikes?
The preceding examples illustrated how investors could use the relationship between 10- and 2-year Treasury yields to anticipate the timing of Federal Reserve interest rate hikes
...
Figure 9
...
The chart
revisits the past four interest rate hike phases of February 1994–February
1995, March 1997, June 1999–May 2000, and June 2004–June 2006, with
each of the phases marked by a rectangular box around the Fed funds rate
graph
...
S
...

Note how the beginning of each interest rate hike was preceded
by a bottoming in the USD/JPY rate (highlighted by circles) due to the

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USD/JPY versus Fed Funds Rate
150

Fed Funds
USD/JPY

140

Spread (Percent)

6

130

5

120
4
110
3

100

2

90

1
0
Jan-93

USD/JPY

7

80
70
Jul-95

Jan-98

Jul-00

Jan-03

Jul-05

Jan-08

FIGURE 9
...

anticipatory nature of currency markets
...
Thus, as economic ﬁgures show marked improvement across the broad sectors and policy makers shift toward a hawkish rhetoric emphasizing inﬂationary risks, bond
yields begin to push higher and the dollar starts to strengthen
...
S
...
S
...

Table 9
...
As mentioned earlier with the
relationship between the 10-2 spread and Fed hikes, the four most recent
rate hikes were preceded by a signal in the yield spread with time lags ranging from 8 to 11 months
...
But it is important to note that the effectiveness of the 10-2 spread signal serves best when it occurs during extended
periods of steady interest rates
...
1 summarizes the duration between the
lows in USD/JPY and the beginning of interest rate hikes
...
Aside from the
interest rate hike of March 1997, where the bottom in USD/JPY preceded it
by as long as 21 months, the other three tightening cycles saw a lag of only
two to six months between the bottoming dollar and the rate hike
...
1 Bottoming Formations in USD/JPY Rate Preceded Tightening Cycles
from the Federal Reserve

10-2 Yield
Spread Peak

Interest Rate
Hike Period

April 1993

February 1994 to
February 1995
March 1997

February
1996
October
1998
July 2003

June 1999 to May
2000
June 2004 to June
2006

Time Elapsed
Between Spread
Peak and Rate
Hike

Time Elapsed
Between
USD/JPY Bottom
and Rate Hike

10 months

6 months

13 months

21 months

8 months

6 months

11 months

2 months

The prolonged 21-month period between the 1995 bottom in USD/JPY
and the 1997 rate hike is due to the 63 percent rally in the dollar between
summer 1995 and spring 1997
...
S
...
S
...
S
...

Determining the direction of U
...
interest rates offers one of the most
vital indicators in ﬁnancial markets, inﬂuencing the capital markets, currencies, equities, and commodities, as well as the medium-term functioning of the U
...
and global economies
...

IS DOLLAR STABILITY A NECESSITY?
In spring 2008, ﬁnancial markets witnessed the early makings of what may
emerge as globally coordinated support for stabilizing the U
...
dollar
...
C
...
S
...
Not only had a rapidly falling dollar further deepened
the emerging economic slowdown in places such as Europe, Japan, and
Canada by excessively lifting their currencies and hampering their exports,

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but it also signaled the acceleration in the dollar price of key commodities,
such as oil and food, which boosted the cost of these imports and lifted inﬂation at home
...
S
...

The U
...
Dollar Index lost 40 percent of its value between January 2002
and April 2008, averaging a decline of 8 percent per year
...
The topic of the
dollar had long been the purview of the U
...
Treasury since the 1990s,
when then Treasury secretary Robert Rubin shaped the so-called “strong
dollar policy
...

In fact, the real currency policy of the United States had grown to be
that of benign neglect as Treasury ofﬁcials tacitly encouraged a depreciating dollar so as to favor U
...
exporters
...
In the aforementioned speech, Bernanke said, “We are attentive to the implications
of changes in the value of the dollar for inﬂation and inﬂation expectations
and will continue to formulate policy to guard against risks to both parts of
our dual mandate, including the risk of an erosion of longer-term inﬂation
expectations
...
S
...

Further signs of the U
...
administration’s worries over its currency appeared when Treasury Secretary Hank Paulson practically urged leaders
of the Gulf States not to depeg their currency regimes from the U
...
dollar
...

The dollar peg has also required these countries to follow the Federal Reserve’s monetary policy of cutting interest rates, which only exacerbated
soaring prices of food and commodities for their citizens
...
A more serious reason for Washington’s reluctance is that breaking away from such a long-held dollar-based
regime would herald a major phase in the dollar’s corroding cycle, and may

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accelerate selling of the currency by speculators as well as longer-term asset managers
...

Having lost control of monetary policy since the creation of the European
Central Bank, Eurozone governments are left with the authority to set ﬁscal
policy and balance their budgets
...

Stability In Oil and Other Commodities
Although oil has proven to be driven by its own supply and demand dynamics, the falling dollar has certainly discouraged OPEC from lowering prices
...

OPEC is loath to repeat the great miscalculation of 1997 when it made
its ﬁrst output increase in four years, raising its production ceiling by
2
...
The 10 percent production increase drove up
total world output by 3
...
The decision was a result of soaring prices into the second half
of the year, caused by Iraq’s refusal to grant admission to United Nations
weapons inspectors that summer
...
40 per barrel in December 1998
...

Tackling Global Inﬂation
Continued erosion in the USD triggers further escalation in oil prices and
ampliﬁes inﬂationary pressures throughout oil-importing nations
...
Other agricultural inputs running on high fuel prices, such as trucks,
also contribute to rising prices in the sector
...

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233

Reducing Fed Policy Dilemma
Since a stable dollar is instrumental in capping energy prices, it reduces
inﬂationary pressures generated from the import pass-through
...

The ﬁrst six months of 2008 worsened central banks’ policy dilemmas
between rising inﬂation and slowing economic growth
...

In the United States, although the Federal Reserve is not bound by an explicit inﬂation target or ceiling, surging inﬂationary pressures have shifted
the central bank’s focus away from slowing growth to that of rising prices
...
Failure to steer the ship carefully may drive
the country into a 1970s style stagﬂation, with soaring inﬂation prices, accelerating unemployment rates, and subpar to negative growth
...
Such measures would only provoke further euro appreciation and
risk jeopardizing the slowdown across the 15-nation region
...
The repercussions of higher oil prices
on U
...
growth have also led to the decline in the dollar
...
Thus, if a robust dollar
succeeds in bringing about stable oil prices, it would ease pressure off the
ECB from having to steer monetary policy largely toward combating rising
energy prices
...
S
...
S
...
S
...
As a result, robust foreign demand helps increase the price of U
...

Treasury securities and caps bond yields
...
4 The Fed hikes of 2004–2007 failed to boost yields in long-term U
...

Treasuries
...
S
...
5 percent to 4
...
Low bond yields had taken
place despite the Federal Reserve’s increase of interest rates during the
same period
...
Figure 9
...

But the situation began to change when foreign net purchases of U
...

Treasury notes and bonds reached a plateau in spring 2004
...
S
...

These doubts further resurfaced as a result of waning foreign participation
in auctions of U
...
government debt, such as 2-, 5-, and 10-year Treasury
securities
...
5 and 9
...
S
...
S
...

Deteriorating conﬁdence in the U
...
currency impacts general investor
perception of the value of holding U
...
assets, barring the potential for
capital gains in these assets
...
Sovereign
wealth funds from the Gulf States, valued at nearly $800 billion, have begun diversifying away from the United States, directing focus toward Asia
and Europe
...
5 trillion
...
S
...
5 Foreign participation in U
...
government 2-year Treasuries began to
wane in 2005
...
S
...
6 Foreign participation in U
...
government 10-year Treasuries descended into a notable downtrend despite occasional recoveries
...
S
...

Several economists have backed the thesis that Gulf State funds will
continue to direct their focus toward U
...
markets as long as they are
bolstered by rising oil revenues
...
S
...
Capital ﬂight and
faulty monitoring of those eventually led to the Latin American debt crises
...
S
...

Tackling Inﬂation in Gulf States and Reducing
Need of FX Depeg
Considering that the currency regimes in Arab Gulf nations are tied to the
U
...
dollar, a falling dollar tends to reduce the value of these local currencies, which raises the value of imported goods and drives inﬂation at
home
...
This has hit countries whose share of
total imports from Europe has risen to as high 30 percent
...
It also curbs OPEC’s concerns with
oil pricing and reduces the need for them to consider alternative-currency
pricing of their USD-denominated oil, such as in euros or a basket of currencies
...

A more stable dollar helps relieve several policy shocks in the U
...
and
global economies via direct and indirect mechanisms
...
S, European, and
Asian ofﬁcials have recognized this fact as they witnessed the extent of
prolonged dollar damage via oil, commodities, international trade, and ﬁnancial market contagion
...
S
...

HOW FAR WILL COMMODITIES
OUTSTRIP EQUITIES?
In Chapter 1 we tackled the relative growth between gold and equities in order to compare the evolution of two popular measures of value: perceived
corporate market value (equities) versus real asset value (gold)
...
A more

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important ﬁnding is that throughout the twentieth century, the equities/
gold ratio had peaked every 35 to 40 years, and followed by a long-drawnout pullback toward the preceding lows, which lasted for 7 to 15 years
...
In order for the ratios to remain
persistent with the patterns of the past 100 years and reach the lows of the
early 1980s, they have to lose at least another 70 percent
...
It would also entail a rise of at least 50 percent
in gold
...

Are Commodities Too Rich for Equities?
What about the rest of commodities? Do the equity/gold ratio patterns apply for other commodities? We start off by comparing the S&P 500 Index
with the Reuters/Jefferies-Commodities Research Bureau Index (CRB), the
most renowned index of commodities prices
...
7 shows that as of

S&P 500 versus CRB Index
500

1800
CRB
S&P 500

450

1600
1400

400

1000

300

800

CRB

350

S&P 500

1200

600
250
400
200

200

150

0
6/9/2008

7/9/2006

8/8/2004

9/8/2002

10/8/2000

11/8/1998

12/8/1996

1/8/1995

2/7/1993

3/10/1991

4/9/1989

5/10/1987

6/9/1985

7/10/1983

8/9/1981

FIGURE 9
...

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the end of June 2008, the CRB had closed at a fresh new all-time high
while the S&P 500 closed at a three-month low, losing 20 percent off its
record highs of October 2007
...
Note how the 2003–2006 period showed
an increase in both indexes as global economic growth extended from the
usual increase in corporate market values, reaching toward an Asian-led
commodities boom
...

As the U
...
economy began to falter in 2007 on the heels of a severe
adjustment in housing, stocks followed suit, bonds were mixed, and commodities took the mantle of the next ﬁnancial bull market
...
8 highlights the increased pace in the growth of commodities relative to equities
during the equities rebound of 2003–2006, before the momentum turned
largely in favor of commodities and dragged the S&P 500/CRB ratio to 12year lows
...

Despite the 12-year lows in equity/commodity ratios, the current price
trend has yet to unfold in order for the ratio to revert to the lows of the
early 1980s
...
9, where the equity/
commodity ratio is halfway toward reaching its historical lows
...

S&P 500 / CRB Ratio Extends to 12-Year Lows

S&P 500 / CRB Ratio

8
...
0
6
...
0
4
...
0
2
...
8 The S&P 500/CRB ratio dip to 12-year lows as commodities thrive
across the board, while equities are hit by economic slowdown and ﬁnancial market
erosion
...
0
8
...
0
6
...
0
4
...
0
2
...
0
0
...
9 Past history shows commodities have yet to eclipse equity indexes,
a possibility with signiﬁcant implications for currencies
...
We found that the rally in
gold had begun in 2001, followed by an intensiﬁcation in oil prices in 2002,
which was later joined by food and agriculture materials in 2006
...
The relationship
between gold and oil has been highlighted by a complete leadership in the
fuel relative to the metal and other commodities
...
S
...
The rationale is that a plummeting ratio is a reﬂection of an excessive rise in oil prices, whose marked
appreciation relative to gold signals cost and inﬂationary repercussions for
importers and consumers
...
10 illustrates that the gold/oil ratio fell
to a record low of 6
...
2 prevailing since 1971
...
Such a development will likely
maintain pressure on the U
...
dollar via its inverse relationship with gold
...

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The Gold/Oil Ratio
40
35
30
25

Historical monthly
average stands at 15
...
10 As the gold/oil ratio tumbles to record lows, reaching less than
half of its historic average, the implications for U
...
growth remain ominous
...
0 or 10
...
Such an event would be accompanied by a signiﬁcant rebound in the U
...
dollar as falling oil prices
ease the strain off the U
...
and other oil importers
...

Chapter 8 made the case for a prolonged increase in the current commodities boom
...
And in looking at the commodities implications of further declines in
the equity/gold ratio, it appears certain that real-asset values of tangibles
such as metals, energy, and agriculture/food products will maintain their
upward trajectory
...
S
...
S
...
S
...
A considerable amount
of statistical exercise has been undertaken in dissecting the correlations
and causalities involving partisan control of Congress, midterm elections,
balance of power between White House and Congress, and the impact of
double-term presidencies
...

In Table 9
...
S
...
2 The Dollar, Equities, Economy, and Bipartisan Politics

Year

Political
Party
Controlling
the White
House

Partisan
Control in
Congress

1971
1972

Republican
Republican

Democrat
Democrat

−8%
−1%

11%
16%

No recession
No recession

1973
1974
1975
1976

Republican
Republican
Republican
Republican

Democrat
Democrat
Democrat
Democrat

−7%
−6%
6%
1%

−17%
−30%
31%
19%

Recession
Recession
No recession
No recession

1977
1978
1979
1980

Democrat
Democrat
Democrat
Democrat

Democrat
Democrat
Democrat
Democrat

−7%
−9%
−1%
6%

−12%
1%
12%
26%

No recession
No recession
No recession
Recession

1981
1982
1983
1984

Republican
Republican
Republican
Republican

Split
Split
Split
Split

16%
12%
13%
14%

−10%
15%
17%
1%

Recession
Recession
No recession
No recession

1985
1986
1987
1988

Republican
Republican
Republican
Republican

Split
Split
Democrat
Democrat

−19%
−16%
−17%
8%

9%
13%
2%
11%

No
No
No
No

1989
1990
1991
1992

Republican
Republican
Republican
Republican

Democrat
Democrat
Democrat
Democrat

1%
−11%
2%
6%

21%
−7%
21%
4%

No recession
Recession
No recession
No recession

1993
1994
1995
1996

Democrat
Democrat
Democrat
Democrat

Democrat
Democrat
Republican
Republican

5%
−8%
−4%
4%

7%
−2%
25%
17%

No
No
No
No

1997
1998
1999
2000

Democrat
Democrat
Democrat
Democrat

Republican
Republican
Republican
Republican

13%
−6%
8%
9%

24%
21%
16%
−12%

No recession
No recession
No recession
Recession

2001
2002
2003
2004

Republican
Republican
Republican
Republican

Democrat
Democrat
Republican
Republican

7%
−13%
−15%
−7%

−15%
−31%
21%
8%

Recession
No recession
No recession
No recession

2005
2006

Republican
Republican

Republican
Republican

12%
−8%

3%
11%

No recession
No recession

2007
2008*

Republican
Republican

Democrat
Democrat

−8%
−6%

3%
−15%

No recession
—

*As of July 3, 2008
...
S
...
The data for
2008 are valid through July 3, 2008
...
(The current year, 2008, is included even though the
year has not ended at the time of this writing
...
Seven of the 20 negative years occurred when the White House and Congress were controlled by the same
party
...
The years 1990 and 1998
were the only negative dollar years where the decline was preceded and
followed by an increase in the currency
...
The subsequent Fed rate
cuts dragged the dollar across the board
...
Similarly, all but one of the 18
years of dollar gains occurred in a string of at least two consecutive years
...
S
...

Such patterns reinforce the notion that currencies move in trends, particularly a widely traded currency such as the dollar
...

The impact of U
...
presidential and midterm elections on currency
markets was especially prominent during the controversial 2000 presidential elections and the 2006 midterm elections
...
Bush
...
Inaccurate media reporting of the 2000
election, erroneously declaring candidate Al Gore the winner, prompted
sharp but short-lived declines in the U
...
dollar
...

Stock Market Performance
The stock market’s performance is measured by the S&P 500, which is
a broad and frequently used index for benchmarking fund performance
...
Of
the 28 years of positive stock performance, 19 occurred during bipartisan
control between the White House and Congress
...
At time of this writing, the dollar is down 6 percent and
stocks are down 15 percent year-to-date
...
In the early 1980s, the Fed’s
staunch anti-inﬂation war under the command of Paul Volcker boosted interest rates toward 20 percent, rendering the dollar an attractive return
on foreign investors’ funds, while stocks recovered as inﬂation was dampened and oil prices retreated
...
S
...

Economic Performance
The criteria used to determine whether the economy fell in a recession
in a given year is the number of quarters showing negative GDP growth
...
At the time of this writing, economic reports are increasingly
pointing to a recession in 2008, but the organization in charge of ofﬁcially
declaring U
...
recessions has not yet done so
...
Due to this formality, 2008 is excluded from the recession
count, leaving us with eight recessions between 1971 and 2007
...
Regarding the sharing
of power between Congress and the White House, seven of the eight recessions took place during a bipartisan split (1973, 1974, 1980, 1981, 1982,
1990) while one occurred in 1980 during dual control by the Democrats
...
S
...
Going into a presidential election year in U
...
politics, ﬁnancial markets fret about the potential for adverse tax consequences of
a Democratic president, whereby the prevailing tax cuts will not be renewed after their 2010 expiration
...
The dollar, which was
already under pressure as the Fed ended its rate hikes while other central
banks continued tightening, accelerated its decline across the board
...
Markets will closely watch
the escalating rhetoric out of Washington proposing regulations by curbing
speculation in commodity markets
...
S
...

The effect would not be too dissimilar from the delisting of several foreign companies in U
...
equity exchanges as a result of the Sarbanes-Oxley
Act of 2002 (SOX), which expanded audit procedures for publicly traded
companies
...
1 Non-U
...
companies choose to cross-list in the United States, using the American Depositary Receipts (ADRs), which represent an ownership interest in securities
of non-U
...
companies
...
S
...
But the SOX Act has prompted foreign
companies to delist from U
...
exchanges as the costs of compliance outweigh the beneﬁts of cross-listing
...
S
...

U
...
Treasury Secretaries
and Dollar Performance
As the two-term Bush administration went through three Treasury secretaries and a 35 percent decline in the value of the dollar in a period of eight
years, we reﬂected on the relationship between the background of U
...

Treasury secretaries and the value of the U
...
currency
...
nysscpa
...
htm
...

James Baker, Treasury secretary under the second Reagan administration, led a historic intervention in the mid-1980s to drive down the overvalued dollar in coordination with the world’s most powerful economies
...
When President George W
...
Or we could
rephrase that sentence to say that none of his Treasury secretaries found
it a priority to support the currency, considering the currency’s excessive
strength at the early stages of the presidential ﬁrst term
...
3 highlights the relation between the backgrounds of former
U
...
Treasury secretaries and the value of the U
...
dollar under the tenure
of those secretaries since the currency became freely ﬂoating in 1971
...
Bill
Simon of Salomon Brothers (1974–1977), Donald Regan of Merrill Lynch
(1981–1985), and Robert Rubin of Goldman Sachs (1995–1999) served
during the best rallies for the U
...
currencies
...
3 U
...
Treasury Secretaries and the Value of the Dollar
Performance
of Dollar
Index

Treasury
Secretary

Employment Prior
to U
...
Treasury

John Connally
George Schultz

Texas governor
Dept
...

Feb
...
7
+8
...
1977
Jan
...
1979

+5
...
2%

Textron Inc
...
S
...
S
...
1979–Jan
...
1981–Feb
...
1985–Aug
...
1988–Jan
...
1993–Dec
...
1995–July 1999
July 1999–Jan
...
2%
+68
...
1%
−5
...
0%
+13
...
5%

Alcoa Inc
...

Goldman Sachs

Jan
...
2002
Feb
...
2008

−9
...
6%
−15
...
Michael Blumenthal (1977–1979), James Baker
(1985–1988), Paul O’Neill (2001–2002), and John Snow (2003–2006) had
signiﬁcant experience in policy making and industry rather than banking
or ﬁnancial services; their tenure as Treasury secretary saw mostly dollar
weakness
...

The underlying rationale is that secretaries with a background other
than banking have generally preferred a weaker dollar in order to boost the
priorities of U
...
exports, domestic industry, and employment
...
S
...
Naturally, the performance of the dollar has largely been a function of U
...
economic growth
and interest rates relative to the major economies
...
S
...

The Breaking of a Pattern
Yet, just as prominent as the relationship between U
...
Treasury secretaries and the value of the dollar has proven to be over the past 40 years, so
has the break in the relationship during the term of Secretary Hank Paulson, a former CEO of Goldman Sachs, arguably the world’s most successful investment bank
...
Paulson served during one of the worst two-year periods in the
history of the dollar, which fell 15 percent in trade-weighted terms, 24 percent against the euro, and 18 percent against the yen
...
Those cyclical problems have compounded the damage
in the dollar due to a prolonged slowdown in the U
...
economy, which
was accompanied by deepening erosion in the capital structure of U
...

banks and continued instability in the overall ﬁnancial system
...
S
...
S
...
While one cannot disregard the considerable impact of a U
...
slowdown on the world economy,

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the cyclical and structural advancement of emerging economies in Asia,
Eastern/Central Europe, and South America has increasingly shielded capital and trade ﬂows from the repercussions of a U
...
recession
...
As long as the greenback remains the world’s reserve currency used for invoicing oil and other major commodities, stabilizing its value is paramount in averting a global inﬂationary spiral at a
time of slowing world growth
...
S
...
S
...
When President Bush appointed
Mr
...
S
...
S
...
S
...
From a strict currency perspective, the goal of the appointment was to further pursue a competitive dollar without compromising the world’s conﬁdence in it
...
Paulson could avoid the
currency impact of the Fed’s aggressive interest rate cuts resulting from
what is increasingly becoming the most penetrating credit crisis of the last
sixty years
...
S
...
S
...

Whether evaluating the case for a Fed rate hike, questioning the relevance
and importance of dollar stability, or assessing the long-term direction of
commodities relative to equities, such topics are likely to comprise part
of the long-term thinking in ﬁnancial markets in general and currencies in
particular
...
The main goal has been to incorporate the ﬂows in commodity, equity, and bond markets into currency dynamics, with a detailed look at the
principal drivers of central bank policy
...
Nor is it a matter of chance that the secular

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CURRENCY TRADING AND INTERMARKET ANALYSIS

U
...
Dollar Index

160
7-year bear
market
(1973–1979)
–20%

140
120

5-year bull
(1980–1984)
+83%

10-year bear
(1985–1994)
7-year bull
–47%
(1995–2001)
+47%

7-year bear
(2002–2007)
–36%

100
80
60
Jan-07

Jan-04

Jan-01

Jan-98

Jan-95

Jan-92

Jan-89

Jan-86

Jan-83

Jan-80

Jan-77

Jan-74

Jan-71

FIGURE 9
...
Understanding the interrelationships molding these markets together is essential in
grasping ﬁnancial markets forces with minimal confusion and distraction
from what often can be noise and corrective price patterns
...
11
summarizes the journey of the U
...
Dollar Index since 1971
...
And with the multitude of new currencies now becoming available for trading by retail and institutional investors, effective ranking of FX performance must go beyond comparing
returns simply against the dollar or the euro
...

Last but not least, ﬁnancial markets make little sense without understanding the price of money
...
Contrasting and comparing interest rate patterns and cross-market developments can pay major dividends
in determining the next shift in central bank policy and in the price of
currencies
...
“Bullish on Bullion
...
http://
us
...
com/ftgateway/superpage
...

Brice, Steve
...
” AME Info, May
21, 2006
...
ameinfo
...
html
...
County Analysis Briefs 2008
...
eia
...
gov/cabs/Russia/NaturalGas
...

Evans-Pritchard, Ambrose
...
” The
Daily Telegraph, April 30, 2008
...
telegraph
...
uk/money/main
...
xml
...
“Dollar Pegs Spur Global Inﬂation—Bank of England
...
com, June 26, 2008
...
arabianbusiness
...

Greider, William
...
New York: Simon & Schuster, 1989
...
On Money and Markets
...

Kishan, Saijel, and Gavin Evans
...
” Bloomberg, May 5, 2008
...
bloomberg
...

Kosich, Dorothy
...
” Mineweb, May 7, 2008
...
mineweb
...

Mathur, Naveen
...
” New Delhi Television Limited, April 17, 2008
...
ndtvproﬁt
...
html
...
“Rising Crude Oil Prices Affect the Japanese Economy
...
http://www
...
go
...
pdf
...
Intermarket Analysis: Proﬁting from Global Market Relationships
...

Reuters
...
” Arab News,
December 25, 2007
...
arabnews
...

249

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BIBLIOGRAPHY

Salomon, Steven
...
New York: Simon & Schuster, 1995
...
“Has Sarbanes-Oxley Led to a Chilling in the U
...
CrossListing Market?” CPA Journal, March 2007
...
nysscpa
...
htm
...

Bank of International Settlements www
...
org
Bloomberg Financial Markets www
...
com
Chicago Board Options Exchange www
...
com
Economic Research Service, U
...
Department of Agriculture www
...
usda
...
S
...
eia
...
gov
Federal Reserve Bank of Atlanta www
...
org
Institute of Supply Management

www
...
ws

International Monetary Fund World Economic Report www
...
org
Ministry of International Finance, Japan

www
...
go
...
opec
...
reuters
...
bankofcanada
...
bankofengland
...
uk

www
...
or
...
en

The CIA 2008 World Fact Book www
...
gov/library/publications/the-worldfactbook/
The Economist www
...
com
The European Central Bank www
...
int
The Financial Times www
...
com
The Reserve Bank of Australia www
...
gov
...
rbnz
...
nz

The Wall Street Journal www
...
com
U
...
Bureau of Economic Analysis
U
...
Census Bureau

www
...
gov

www
...
gov

U
...
Commodity Futures Trading Commission
U
...
Department of Labor

www
...
gov

www
...
gov

U
...
Department of the Treasury

www
...
gov

U
...
Federal Reserve Board www
...
gov
U
...
Geological Survey

www
...
gov

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About the Author

shraf La¨di is the head foreign exchange strategist at CMC Markets,
ı
where he oversees the analysis and forecasting functions of G10 currency pairs as well as decisions and trends of the major global central banks
...
His FX analysis has received a wide following for more than a decade, centering on G10
currencies and economies
...
La¨di also created the ﬁrst 24-hour currency web site for
ı
traders and researchers alike on the eve of the creation of the euro
...
His insights also appear in the Financial Times, the Wall Street Journal, Barron’s, the New York Times, Marketwatch, TheStreet
...
He is ﬂuent in English, Arabic, French, and Spanish
...
com
...
See American Depositary
Receipts
Afghanistan:
Soviet invasion and occupation
of, 4, 156, 208
U
...
war in, 67, 69, 169
Agricultural commodities:
global ﬁnancial markets and
prices of, 153
growth rates in developing
nations and, 192
present commodities cycle and,
192
American Depositary Receipts,
244
American Jobs Creation Act of
2004, 92
AMM
...
S
...
See also Bonds;
Commodities; Equities;
Stocks
multifaceted, commodities as,
191
net foreign capital ﬂows into
United States by, 174
percent breakdown in foreign
ﬂows, 175
U
...
, rise in net foreign ﬂows in
2000, 61
Asset market model, 53
Australia, interest rates, and
current account percent of
GDP, 115, 116
Australian dollar (AUD), 54, 71,
137, 221
aggregate returns on, 1999, 55
charting against price of gold, 9,
10
copper prices and boost for, 80,
110
food/grain return on, 213
gold, copper and, 220–221, 222
gold returns in 2000 vs
...
, 14
253

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254
Australian dollar (AUD)
(Continued)
gold’s aggregate annual returns
against, 11, 12
gold’s correlations with, 15
gold’s recent performance
against, 10, 11
metals and growth in, 223
1999 performance of, 56–57
2000 aggregate returns, 60
2001 aggregate returns, 66
2002 aggregate returns, 72
2003 aggregate returns, 78, 79
2005 aggregate returns, 90
2006 aggregate returns, 95
2007 aggregate returns, 102
2000 performance of, 64–65
2001 performance of, 69
2002 performance of, 77
2004 performance of, 89
2005 performance of, 93
2006 performance of, 98–99
2007 performance of, 104
U
...
subprime mortgage market
crisis, unwinding of carry
trades and, 128–129
volatility index vs
...
S
...
See Bank of Canada
BoE
...
See Bank of Japan
Bonds
...
S
...
See Balance of payments

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255

Index

Bovespa equity benchmark index
(Brazil), 214
bps
...
See Brazil, Russia, India,
and China
Britain, gold standard abandoned
by, 2
British pound, 54, 71, 76, 137
aggregate returns, 1999, 55
euro gains vs
...
, 13
gold returns in 2007 vs
...
S
...
S
...
See Brazilian real
Budget balance, dollar vs
...
, 166, 167
unsustainability and ﬁnancing
of?, 170–171
Budget surplus (1990s), 169
Burns, Arthur, 28, 29, 35
Bush, George W
...
See Canadian dollar

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256
Canada, 198
interest rates, and current
account percent of GDP,
115, 116
natural gas exporting by, 216
proven oil reserves in, 217
Canadian dollar (loonie), 54, 71,
76, 224, 247
aggregate returns, 1999, 55
charting against price of gold, 9,
10
energy and, 216–217
food/grain return on, 213
gold returns in 2000 vs
...
, 14
gold’s aggregate annual returns
against, 11, 12
gold’s correlations with, 15
growth in, since 2002, 219
1999 performance of, 57–58
oil-dependent returns for, 218
2000 aggregate returns, 60
2001 aggregate returns, 66
2002 aggregate returns, 72
2003 aggregate returns, 78, 79
2005 aggregate returns, 90
2006 aggregate returns, 95
2007 aggregate returns, 102
2000 performance of, 62–63
2001 performance of, 68
2002 performance of, 77–78
2003 performance of, 81
2004 performance of, 87
2005 performance of, 91–92
2006 performance of, 100–101
2007 performance of, 103–104
2007 record oil and boost in,
102, 103–104
wheat production and, 211–212
Capital account, 53, 162, 170
Capital ﬂows, 51
asset market model and increase
in, 53

Printer: Yet to come

INDEX

identity shifts and, 177–179
interest rate differentials,
driving currencies and, 109
Carry return, 113
Carry trades, 11, 86
bond investing and, 113
emergence of, 91
foreign exchange markets and
growth in, 109, 112–118
global, low Japanese rates and,
117, 118
hedge funds and, 120
heightened, yen weakness fuels
advances in equities via, 122
intensiﬁed risk appetite and use
of, 133
Japanese yen crosses guided by,
104
Japanese yen’s 2007 sales and,
106
Japan’s 1980 bubble burst and,
117, 118
phases of increased risk appetite
and rise in, 125
proﬁtability and unwinding of,
114
risk appetites and, 1999–2007,
135
straightforward nature of, 121
Swiss franc and funding of, 130
Swiss franc’s 2007 performance
and, 106
U
...
subprime mortgage market
crisis and unwinding of,
128–129
USD/JPY, S&P 500, global
equities and, 120
into yen and extension of, into
other currencies, 128
Carter, Jimmy, 30, 31, 35
Central Bank Agreement on Gold,
6
Central Bank of Kuwait, 186

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10:45

Index

Central banks, 51
currency reserve diversiﬁcation
and, 185–186
gold sale agreements and, 5–6,
26
inﬂationary spiral of 1979–1980
and, 37
U
...
dollar and reserves for,
137
Cheney, Richard, 127
CHF
...
S
...

previous cycles in, 193–196
dollar correlation with, 207, 208
dollar stability and stability in,
232
global ﬁnancial markets and
prices of, 153
gold’s performance and trends
in, 22–23
growth of, relative to equities,
237–239
as multifaceted asset class, 191
New Zealand dollar and rise in,
2004, 86
number of large booms in, 193,
194
rising, realities of new global
economy and, 189
supercycle in, falling dollar and,
191, 193, 247
2000 rally in, 193, 195
U
...
dollar rally in 2005 and,
90–91
Commodities-oriented funds,
investor interest in, 193
Commodity classes, 196–207
biofuels revolution, 204–206
copper’s growth, 202–203
dairy price rises, 206

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258
Commodity classes (Continued)
food, grains and global appetite,
203
fuel price increases, 206
gold’s multifaceted shine,
199–202
Mexico’s oil output, 198–199
rising middle class in emerging
economies, 203–204
Russian oil output, 198
supply realities, 198
tariffs, 206–207
weather, 207
Commodity currencies, U
...
dollar
and 2003 returns, 78–84
Commodity price indexes, U
...

dollar and, 192
Complacency, exposing, volatility
index used in, 124–129
Congress (U
...
), 240, 242
Convertible currencies, Bretton
Woods Agreement and
launch of, 2
Copper, 202–203
Australian dollar boost and
prices for, 80, 110
China’s demand for, 48, 221
currency plays in, 220–223
developing nations and demand
for, 193
gold outshined by, 202
long term fundamentals and,
219, 224
price performance in, 196
Corn, 208
biofuels revolution and, 204
developing nations and demand
for, 193
net speculative positions in,
205
price performance in, 196
wheat and soy prices vs
...
See Reuters/
Jefferies-Commodities
Research Bureau Index
Credit market, U
...
, subprime
mortgage market crisis and,
128, 149, 150
Credit rating agencies, defaults
and, 175
Credit risk, corporate bond
spreads and measurement
of, 133
Crops, rise in, 203
Currencies
...
S
...
, 169, 170
inverse relationship between
interest rates and, 116
subcomponents of, 162
Current account deﬁcits:
ﬁnancial account surplus vs
...
, 166, 167
U
...
, cost of ﬁnancing for, 181
U
...
, old problem, new
challenges with, 165–168
Current account surplus nations,
interest rates and, 115, 116
Dairy products:
New Zealand dollar and, 211
rise in, 206
DAX index (Germany), 122
Debt:
personal, British pound’s 2007
performance and, 107
U
...
public, rise in foreign
ownership of, 177–179
Debtor nations, risk and, 115
Deﬁcits, twin, in United States,
162–165
Deﬂation, Japanese policy makers
and, 127
DEM
...
See Supply
and demand
Democrats:
budget surplus and, 169
dollar performance and, 242–243

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260
Deutsche mark, 185
falling oil prices, dollar and
impact on, 41
Germany’s adoption of, 1–2
U
...
dollar’s performance
against, early 1980s, 36, 37
Developing nations:
accelerating growth rates in,
192
ripe outlook for food and grains
in, 208–210
Diesel cars, 215
Dietary trends:
Asian, food rise and, 204
beef and poultry consumption in
China, 209
Dollar
...
S
...
, 223
oil thrives on, 46
yield curve signals peak of, 226
Dow Jones Industrials Index, 236
equity/gold ratio, 19, 20
pricing of, in gold terms, 16–18
U
...
dollar’s 2001 performance
and, 67
Droughts, agricultural production
and, 207
Dubai, G7 2003 meeting in, 78, 83
“Dumb money,” 176
East Asia:
currency reserves and
investments by, 181
yield curve inversion and 1998
market crisis in, 146
ECB
...
See European currency unit
Elections:
currency effect and, 244
currency markets and, 62,
242–243
Emerging economies, food rally
and, 203–204
Employment, 10-year yield minus
fed funds spread vs
...
See also Oil; Oil prices; Oil
price shocks
accelerating growth rates in
developing nations and,
192
currency plays in, 216–219
global ﬁnancial markets and
price of, 153
present commodities cycle and,
192
Environmental factors, risk
tolerance and, 112
Equilibrium, rate of, 53
Equities
...
monetary
assets, 16–18
growth of commodities relative
to, 237–239
net foreign capital ﬂows into
United States and, 174
as percentage of total net
foreign purchases, 176
rising risk and drop in, 123

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Index

U
...
, dot-com boom (1999–2000)
and, 46
U
...
, Iraq invasion of Kuwait and
decline in net purchases of,
43, 44
Equity indexes, 121–123
Equity-to-gold ratios, 19–21, 237
ERM
...
See Exchange-traded funds
Ethanol, 204, 208–209, 211, 215
Eurodollar market, surge of, in late
1960s, 2
Euro (EUR), 53, 137
aggregate returns, 1999, 55
as anti-dollar, 75, 76, 87, 127
British pound vs
...
, 13
gold returns in 2007 vs
...
S
...
30 level regained by, 98
1999 performance of, 58–59
polarity between U
...
dollar and,
75, 76
sell-off of 2000, 64
as threat to dollar’s global
reserve status, 189
2000 aggregate returns, 60
2001 aggregate returns, 66
2002 aggregate returns, 72
2003 aggregate returns, 79

Printer: Yet to come

261
2006 aggregate returns, 95
2007 aggregate returns, 102
2000 performance of, 63–64
2001 performance of, 69
2002 performance of, 74–76
2003 performance of, 81
2004 performance of, 86–87
2005 performance of, 93–94
2006 performance of, 97–98
2007 performance of, 105
USD-gold inverse relationship
and, 7, 8
volatility index vs, 2007–2008,
128
Europe:
central banks’ gold sale
agreements in, 5–6
interest rates, and current
account percent of GDP,
115, 116
European Central Bank, 7, 59, 60,
75, 85, 96, 100, 102, 126, 232
dollar stability, oil price stability
and, 233
euro’s 2001 performance and, 69
euro’s 2000 sell-off and
intervention by, 64
European currency unit, 185
European Monetary Union, Poland
and, 214
European Union, 8, 92
European Union Constitution,
France’s rejection of
proposal for, 93
Eurozone, 7, 8, 9, 15, 46, 47, 72, 75,
92, 93, 105
British pound’s 2001
performance and, 68
food spending in, 203
gold sale agreements and, 5, 6
net debtor status of, 164
1999 performance of euro and,
58

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262
Eurozone yield spreads, EUR/USD
vs
...
See Food and Agriculture
Organisation
Farmers:
biofuel revolution and, 204, 206,
208
rising fuel prices and, 206
Farm products, U
...
producer
price index for, 195
FDA
...
See Foreign direct investment
Fear index (VIX), 123
Federal Drug Administration, 111,
112
Federal Open Market Committee,
147, 150
Federal Reserve, xiv, 25, 84, 126,
136, 159, 175, 186
bottoming formations in
USD/JPY rate precedes
tightening cycles from, 229,
230
Burns’ chairmanship of, 28, 29
conclusion of two-year
tightening campaign in 2006
by, 94, 100
dot-com boom and rate cuts by,
46
euro’s 2000 sell-off and
intervention by, 64
ﬁrst dollar crisis (1977–1979)
and, 30, 32

Printer: Yet to come

INDEX

ﬂat yield curves, interest rates
and, 139, 140, 141, 226
inﬂation during 2000 and
interest rates raised by, 60
1998 yield curve inversion and,
146, 147, 226
normalization of monetary
policy in 2005 by, 92
prolonged interest cuts by, early
2000s, 78
rate hikes by, 2004–2005, 47
stable dollar and, 233
subprime mortgage market
crisis and policy priorities
of, 129
tight monetarism in the 1970s
and, 4
2000 yield curve inversion and,
147–148
2006–2007 yield curve inversion
and, 148–153, 226–227
U
...
dollar’s 1999 performance
and rate hikes by, 58
U
...
dollar’s 2004 performance
and rate hikes by, 89
U
...
recession in 2001 and
aggressive cuts by, 65, 67
Volcker’s chairmanship of, 35,
36, 37
Fed funds rate:
market crisis in East Asia,
Russia, Brazil and, 147
10-year rate vs
...
S
...
,
227–228
USD/JPY vs
...
, 172
Fixed exchange rates, Bretton
Woods Agreement and
launch of, 2
Flat yield curves, 139, 140
Food:
currency plays in, 210–214
daily global consumption of, 204
developing world and ripe
outlook for, 208–210
paradigm shift in pricing of, 224
present commodities cycle and,
192
rising middle class and rise in,
203–204
Food and Agriculture Organisation
(United Nations), 224
Ford, Gerald, 30
Ford administration, stagﬂation
during, 31
Foreign assets, U
...
residents’
purchases of, 182–184
Foreign capital, U
...
dependency
on, 171
Foreign direct investment, 163
annual net, into United States,
180
mergers and acquisitions and,
179–181
Foreign exchange ﬂows:
asset market model and, 53
gross positions vs
...
S
...
See British pound
GDP
...
See
Afghanistan; Arab-Israeli
War; Asian crisis
(1997–1998); Cold War;
Elections; Iraq War; Kuwait;
Middle East
Germany, 46
DAX index, 122
falling oil prices, dollar and
impact on, 39–41

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264
Germany (Continued)
ﬁrst dollar crisis, 1977-1979 and,
31, 32
1999 euro performance and,
58–59
Gifts, 162
Global carry trade, low Japanese
rates and, 117, 118
Global economy, new, realities of,
189–190
Gold
...
S
...
monetary
assets, 16–18
equity-to-gold ratios, 19–21
falling production in, 16, 17
identifying currency leaders and
laggards against value of,
8–11
inﬂation (U
...
), vs
...
S
...
, 21, 201
speculators and, 21–22
supply side of, 201–202, 224
2000 returns vs
...
various
currencies, 14
U
...
dollar vs
...
S
...
See U
...
dollar
Greenﬁeld investments, 179
Greenspan, Alan, 64, 144–145
Gross domestic product, 29
...
S
...
,
172
Group of Five, world interventions
against strong dollar,
1985–1987 and, 39
Growth recession, deﬁned, 38
G7 nations:
Australian dollar’s 1999
performance and, 57

Printer: Yet to come

265
Dubai meeting of, 2003, 78, 83
oil shocks and, 33
G10 economies, Japanese yen,
Swiss franc and, 115
Gulf Cooperation Council (GCC)
group of nations, uniﬁed
currency and, 185
Gulf nations:
commodities price moves and,
192
dollar holdings in currency
reserves of, 186
dollar peg and, 231–232
focus of sovereign wealth funds
from, 235–236
inevitability of currency
diversiﬁcation in, 187–189
inﬂation and currencies pegged
to falling dollar in, 187
oil wealth diversiﬁcation in, 181
Gulf War (1990–1991), 41–44
net foreign purchases of U
...

assets during, 44
Hang Seng index (Hong Kong),
122
Hedge funds, 113
carry trades and, 120
U
...
subprime mortgage market
crisis and, 128, 149
High-yield corporate spreads,
132–134
Historical producer price index,
195
Homeland Investment Act, 7–8, 92
Homeland Security, 169
Hong Kong:
Asian crisis of 1997–1998 and, 45
Australian dollar’s 1999
performance and, 57
Australian dollar’s 2001
performance and, 69
Hang Seng index, 122

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266
Housing prices:
Australian dollar’s 2004
performance and slowing
in, 89
British pound’s 2004
performance and decline in,
87, 88
British pound’s 2007
performance and decline in,
107
soaring, run-up in trade deﬁcit of
late 1990s and, 166
U
...
, beginning decline in, 2006,
94, 97, 100, 238
U
...
, 2007 credit crisis and
economic impact of
deterioration in, 102, 108,
128
U
...
, volatility and slowdown in
rise of, 127
U
...
, 2006–2007 yield curve
inversion and dislocations
in, 148, 149, 152
yield curve predictions about
slowdown in, 149
Hurricane Katrina, 136
Hurricane Rita, 136
IEA
...
S
...
gold, 4, 5
Vietnam War and, 27, 35
Infrastructure boom, from Gulf
nations to Far East, 199–200
Interest rate differentials, ensuing
opportunities obtained
from, 117
Interest rate parity, 52
Interest rates, 51, 159
budget deﬁcit and, 169
central banks of
commodity-based
economies and rise in, 2002,
72
currency carry trades and, 113
current account and budget
deﬁcits vs
...
S
...
See Dot-com
bubble
Inverted yield curves, 141
1998, 146–147
rationale of implications with,
142
recessions and, 141, 142, 143,
145
timing of dollar peak, stocks
peak, and rate cuts from
start of, 151
2000, 147–148
2006–2007, 148–153
U
...
dollar and, 151
Iran, 155, 187
Iranian Revolution, 4, 32, 34
Iran-Iraq war, 32, 34
Iraq, Kuwait invaded by, 41–44, 87,
156, 157, 242

Printer: Yet to come

267
Iraq war (2003–), 22, 169, 191
British pound and Blair’s
support for, 76–77
broad equity indexes and run-up
to, 134
Canadian dollar and Canada’s
vote against, 77
euro gains vs
...
S
...
See Interest rate parity
ISM Manufacturing Index, 144
Italy, 1999 euro performance and,
59
Japan, 46, 78
bursting stock bubble in,
1986-1998, 56
equity bubble bursts in (early
1990s), 117
falling oil prices, dollar and
impact on, 39–41
ﬁrst dollar crisis in, 1977-1979,
31, 32
interest rates, and current
account percent of GDP,
115, 116
as net lender nation, 164
Nikkei-225 equity index, 122
U
...
Treasuries accumulated by,
178–179
Japanese stocks and bonds, net
foreign inﬂow into,
1996–2000, 57
Japanese yen crosses, carry trades
and guiding of, 104

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268
Japanese yen (JPY), 53, 71, 76, 109,
133, 134, 136, 137, 158
aggregate currency returns,
1999, 55
bottoming formations in rate of,
preceding cycles from
Federal Reserve, 229, 230
carry trades, 1980s bubble burst
and, 117, 118
carry trades and unwinding of,
119
falling, global stocks rally at
expense of, 122
falling oil prices, dollar and
impact on, 40–41
Federal Reserve’s interest rate
rise (2004) and S&P 500 vs
...
, 228–230, 229
gold measured against, 9, 10
gold returns in 2000 vs
...
, 14
gold’s aggregate annual returns
against, 11, 12
gold’s correlations with, 15
gold’s recent performance
against, 10, 11
higher global interest rates and
effect on, 2002–2006, 95
high interest in low yield of,
116–120
net speculative futures
positions, vs
...
S
...
S
...
S
...
, 1975–1978, 30–33
volatility index vs
...
, 2007–2008,
128
Jewelry, gold demand and, 200
Jobs slowdown, yield curve
predictions about, 149
Johnson, Lyndon, 35
Junk bonds, 132
Kiwi
...
See Swedish krona
Kuwait:
currencies of, tied to basket of
international currencies,
187
diversiﬁcation of sovereign
wealth funds from, 189

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JWBT010-Laidi

October 17, 2008

10:45

Index

dollar holdings in currency
reserves of, 186
Iraq’s invasion of, 41–44, 87, 156,
157, 242
Latin America, commodities price
moves and, 192
London, England, terrorist
bombings in, July, 2005, 82
Long-term bonds, carry trades and,
113
Long Term Capital Management
hedge fund, collapse of,
147, 152, 226, 242
Long-term interest rates, 159
Greenspan’s “conundrum” and
Bernanke’s problem related
to, 144–145
inverted yield curves and, 142
recessionary signal and, 146
trends in, and predicting
turnarounds in stocks,
146
weak foreign ﬁnancing of deﬁcit
and, 189
Louvre Accord (1987), 41, 231
Low-yielding currencies, rising
risk appetite and decline in,
125
Maquiladora industry (Mexico),
217
Market volatility, volatility index
and measurement of,
133
Mergers and acquisitions (M&As),
foreign direct investment
and, 179–181
Merrill Lynch, 245
Metal currencies:
growth in, 223
returns for, 222

Printer: Yet to come

269
Metals
...
S
...
S
...
, 212
rise in, 206
Milk production, New Zealand
dollar and, 211, 212
Mining companies, labor issues
and, 219, 221
M-1, inﬂation in late 1970s and, 36

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October 17, 2008

10:45

270
Monetary assets, interaction
between gold and, 19–20
Monetary policy
...
S
...
See National Bureau of
Economic Research
Negative investment position, 163
Negative-yield spreads, 142
Net ﬁnancial ﬂows, U
...
dollar vs
...
, 13
gold returns in 2007 vs
...
S
...
, 129
NIAEs
...
:
Burns appointed by, 28
gold standard abandoned by, xi,
2, 26–27
Norway, crude oil exporting by,
216
Norwegian krone, 224
energy and, 216
growth in, since 2002, 219
oil-dependent returns for, 218
Nuevo sol (Peru), 224
gold, copper and, 221, 222
metals and growth in
NZD
...
See Organization for
Economic Co-operation and
Development
Oil
...
, 48
U
...
dollar vs
...
S
...
S
...
, 26
U
...
fuel demand and, 215
volatile Asian growth and
impact on, 1990s, 45
Oil price shocks:
ﬁrst, 1973-1974, 28–30
global recessions and, 25
inﬂation boosted and growth
hampered by, 32, 33
Iraq’s invasion of Kuwait and,
41–44
mounting inﬂation, falling dollar
and, 27–28
of the 1970s, xi
second oil shock (1978–1980),
32, 38, 156
super dollar of 1980–1984 and,
34–38
Oil standard, from gold standard to
(1970s–1980s), 26–32
O’Neill, Paul, 245, 246

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10:45

Printer: Yet to come

272
Organization for Economic
Co-operation and
Development, 214, 224
Organization of Petroleum
Exporting Countries
(OPEC), 155
Asian crisis and miscalculation
by (1997–1998), 44–45, 157,
188, 199, 232
currency reserve diversiﬁcation:
Middle East and, 185–187
dollar, oil demand and, 187
Iranian Revolution and price
hikes by, 32
Iran-Iraq war and, 33
1986 oil price plunge and, 34
oil embargo of 1973 and, 27, 28
price hikes of the 1970s and, 4
supply realities, oil environment
and, 215
Paulson, Henry, 231, 245, 246, 247
Pebble Beach Golf Club, 180
PEN
...
S
...
S
...
S
...
See British pound
Purchasing power parity (PPP), 52,
53
Qatar:
diversiﬁcation of sovereign
wealth funds from, 189
dollar holdings in currency
reserves of, 186
Quotas, 52
Rand (South Africa):
gold, copper and, 221–223
South Africa’s falling gold
production and, 221–222,
223
Rate of equilibrium, 53
RBA
...
See Reserve Bank of New
Zealand
Real
...
See also Housing
prices
Australia’s slowdown in, 85
Japanese yen and, 125
Recessions, 159
economic performance and, 243
gold:oil ratio, interest rates and,
153–158
gold:oil ratio and, 154, 239, 240
growth, deﬁned, 38
historical relationship of gold:oil
ratio and, 154–158, 239
inverted yield curves and, 141,
142, 143, 145
NBER deﬁnition of, 155
1973–1975, gold:oil ratio and,
155
1980–1981, inﬂation and, 37

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10:45

Index

1980–1982, gold:oil ratio and,
155–156
1990–1991, gold:oil ratio and,
156–157
2001–2002, gold:oil ratio and,
157–158
2007–2008, gold:oil ratio and,
158
U
...
2001 slowdown and, 65,
67
Reﬂationary monetary policy
(Federal Reserve), 78
Regan, Donald, 245
Regional GDP, growth in, 51
Renewable fuel, 208
Renewable Fuel Standard, 208
Republicans:
budget balance and, 169
dollar performance and,
242–243
election of 2000 and, 62
steel production tariffs and
Congressional elections,
2002, 72
Reserve Bank of Australia, 69, 80,
85, 96, 100, 126, 220
Reserve Bank of New Zealand, 73,
85, 96–97, 100, 106, 126
Reuters/Jefferies-Commodities
Research Bureau Index,
196, 200
extends to 12-year lows, 238–239
S&P 500 Index vs
...
See Renewable Fuel Standard
Rice, 206–207, 210
Rising complacency, volatility
index and, 124–129
Risk:
increasing, forms of, 111
management of, 111
Treasury bonds vs
...
, 2
Rubin, Robert, “strong dollar
policy” and, 230, 245
Runaway markets, chasing, 130
Russia, 199
currency crisis of 1998 in, 59
moratorium on $70 billion debt
declared by (1998), 119
natural gas exporting by, 216,
217
oil peak in?, 198, 215
yield curve inversion and 1998
market crisis in, 146, 147
Russian ruble, 224
energy and, 217
growth in, since 2002, 219
oil-dependent returns for, 218
Salomon Brothers, 245
Sarbanes-Oxley Act of 2002, 244
Saudi Arabia, 49, 108, 187
Al Ghawar ﬁeld in, 215
Iran-Iraq war and oil production
by, 32–33
proven oil reserves in, 217
Saudi Arabian Monetary Authority,
186
Savings and loan (S&L) crisis
(1980s), 42, 43, 157, 242
SEK
...
See Swiss National Bank
Snow, John, 89, 245, 246
Soros, George, 186
South Africa, gold mining
production declines in, 16,
17, 201, 219
South Korea, Asian crisis of
1997–1998 and, 45
Sovereign wealth funds, 188–189
commodities integrated into,
192
global capital ﬂows shaped by,
234
Soviet Union, Afghanistan invaded
by, 4, 156, 208

Printer: Yet to come

INDEX

Soy, 203
corn and wheat prices vs
...
, 237–238
equity/gold ratio, 19, 20
equity indexes and, 121
extends to 12-year lows, 238–239
pricing of, in gold terms, 16–18
upside to go with, 239
U
...
dollar/Japanese yen vs
...
S
...
, 123, 125
Steel production tariffs, Bush
administration and, 47, 72,
75, 78, 191
Sterling
...
S
...
S
...
S
...
S
...
See Sovereign wealth
funds
Swiss franc (“swissy”), 14, 54, 71,
133, 134, 136, 158, 247
aggregate returns, 1999, 55
carry trades funding and, 130
gold measured against, 9, 10
gold returns in 2000 vs
...
, 14
gold’s aggregate annual returns
against, 11, 12
1999 performance of, 59
rising risk appetite and decline
in, 125
stand-out of, 2007–early 2008,
131
thriving of, during uncertainty,
115–116
2000 aggregate returns, 60
2001 aggregate returns, 66
2002 aggregate returns, 72

Printer: Yet to come

275
2003 aggregate returns, 79
2006 aggregate returns, 95
2007 aggregate returns, 102
2000 performance of, 62
2001 performance of, 68
2002 performance of, 74
2003 performance of, 83
2004 performance of, 86
2005 performance of, 94
2006 performance of, 99
2007 performance of, 106
Swiss National Bank, 5, 14, 62, 68,
83, 86, 94, 99, 100
Switzerland, interest rates, and
current account percent of
GDP, 115, 116
Taiwan:
Asian crisis of 1997–1998 and,
45
Australian dollar’s 1999
performance and, 57
Australian dollar’s 2001
performance and, 69
Taliban, U
...
war against, 67
Tariffs, 52
currency depreciations and,
72
food-trade protectionism and,
206–207
steel production, Bush
administration and, 47, 72,
75, 78, 191
Tax cuts, U
...
, Iraq War and, 46
Taxes, 52
Technology bubble (1999–2000)
...
S
...
, 227–228,
234
minus Fed funds spread vs
...
See Treasury Information
Capital System
Trade balance, 162
Trade deﬁcit, dollar depreciation
and, 166
Trade gap, 163
dollar decline and, 189
oil’s share of total imports and,
167, 168
Traders’ futures commitments,
129–132
Treasury bonds, 132
Treasury Information Capital
System, 174
Treasury secretaries, value of
dollar and, 245
Treasury securities:
dollar performance and,
244–246
foreign holdings of, as share of
public debt, 177–179
Japan’s and China’s
accumulation of, 178,
233–234
net foreign capital ﬂows into
United States and, 174–175
percent breakdown in foreign
ﬂows of, 175, 176
Trends, ends of, 114
Trichet, Jean-Claude, 86, 87, 97
Twin deﬁcits, in United States,
162–165
2-year Treasury auctions, foreign
participation in, 234, 235
2-year Treasury yields, Fed funds
rate vs
...
See United Arab Emirates
Uncertainty, Japanese yen, Swiss
franc and, 115–116
Unemployment:
Carter’s economic policies and,
31
inﬂationary spiral of 1979–1980
and, 37
United Arab Emirates, 108, 186
United Kingdom:
food spending in, 203
FTSE-100 index, 122
interest rates, and current
account percent of GDP,
115, 116
U
...
Treasuries accumulated by,
178
United Nations, 44
United States:
Afghanistan war and, 67
annual net foreign direct
investment into, 180
ethanol production in, 204
food spending in, 203
GDP growth in, 154
global economic growth and,
137
gross external debt of, 181
interest rates, and current
account percent of GDP,
115, 116
as net debtor nation, 164, 171
net foreign capital ﬂows into, by
asset class, 174
net international investment
position of, 170–171
twin deﬁcits in, 162–165
world oil supply and, 49
University endowments,
commodities integrated
into, 192, 224
Upward-sloping yield curves, 139,
140

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10:45

Index

Urbanization, in China, 210
U
...
current account deﬁcit, as
percentage of world GDP to
that in Eurozone, Japan,
emerging Asia, and
oil-exporting nations, 163
U
...
Dollar Index, 150, 240, 248
commodities groups and,
207–208
decline in, 2002–2008, 231
euro’s dominance in, 76
in late 1970s, 31
U
...
dollar stabilization, 230–236
global inﬂation and, 232
globally coordinated support
for, 230
inﬂation in Gulf states and,
236
reducing Fed policy dilemma
and, 233
reinstilling conﬁdence in U
...

markets/assets and,
233–236
relieving pressure on ECB policy
and, 233
stability in oil and other
commodities, 232
U
...
dollar (USD), 161
aggregate returns, 1999, 55
beginning of dollar bear market,
2002, 71–72
bottoming formations in rate of,
preceding cycles from
Federal Reserve, 229, 230
budget and current account
balances vs
...
, during
falling oil, 41
dot-com boom (1999–2000) and,
46
drop to bottom of currency
returns in 2002, 72
end of Bretton Woods system
and devaluations of, 2–3, 28
end of bull market in,
1995–2001, 191
equities, economy, bipartisan
politics and, 241
euro’s polarity with, 74–76
falling, and beneﬁcial impact on
current account, 165–166
falling, oil and: boon for
non-USD importers, 39–41
falling, rising oil prices and,
167–168
Federal Reserve rate cuts, 2001,
and boost for, 67
Federal Reserve’s interest rate
rise (2004) and S&P 500 vs
...
, 228–230
ﬁrst dollar crisis (1977–1797),
30–33
gold and, 1
gold and oil prices vs
...
S
...
, 13
gold returns in 2007 vs
...
, 1975–1978,
30–33
kiwi-related currency pairs
returns, 2002, as greenback
sold across the board, 73
milk prices vs
...
, 173
net yen speculative futures
positions vs
...
S
...
, 125, 126
world intervenes against,
1985-1987, 39–41
yield curve inversions and,
150–151, 226
U
...
Energy Independence and
Security Act of 2007, 208,
215
U
...
Gold Reserve Act, 2
U
...
government bonds, 132
U
...
markets/assets, reinstilling
conﬁdence in, 233–236
USD
...
S
...
market risk:
spreads vs
...
, 2007–2008, 128
high-yielding Australian dollar,
kiwi vs
...
, 125
USD/JPY vs
...
price of,
205
World GDP:
current account as percentage
of, 163

growth in, 51
net foreign assets as percentage
of, 164
World War I, 2
World War II, 208
Yen
...
S
...
See Polish zloty

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October 17, 2008

10:45

280

Printer: Yet to come

Pr a i s e fo r

(continued from front flap)

CURRENCY TRADING AND INTERMARKET ANALYSIS
$70
...
00 CAN

as the oil-producing nations, and the evolution of
power between the Dollar and the Euro
•

Currency trading has increased in size and speed, and
so has its impact on the global ﬁnancial scene
...

Currency Trading and Intermarket Analysis outlines
the tools needed to understand the macroeconomic
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provides you with insights that are essential to making

“Ashraf Laïdi’s book is sure to become an instant classic from Wall Street to Main Street
...
In these turbulent times, the investor
who wants to stay ahead of the curve and reap above average returns, the business
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growth must read this book and a number of times, from cover to cover
...

“A comprehensive guide to the factors that drive the FX market, with a particular emphasis
on the major currency pairs
...
His
online FX analysis has received wide following for
more than a decade, centering on G-10 currencies
the performance of a multi-FX portfolio at the United
Nations, assessed sovereign and project investment

—Susie Gharib, Anchor, PBS’s Nightly Business Report

“Ashraf Laïdi is well known to city journalists as the rising star of the currency markets
...
It is a primer on
thirty years of exchange rate drama
...
”
—Ambrose Evans-Pritchard, International Business Editor

emerging market bonds at Reuters
...
He is the
founder of AshrafLaidi
...

Jacket Design: Barsoom Design

“Ashraf Laïdi has been an invaluable source of insight as global currencies have
endured their ﬁercest bout of turbulence for years
...
”
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HOW TO PROFIT FROM
THE SHIFTING CURRENTS
IN GLOBAL MARKETS

risk for Hagler Bailly and the World Bank, and analyzed

“Ashraf Laïdi’s insights on the dollar have enlightened the millions who have seen him
on TV or read his analysis
...
Valuable information for all
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Prior to joining CMC, Laïdi monitored

—Brad Setser, Fellow, Geoeconomics, Council on Foreign Relations

CURRENCY TRADING

And much more

—Alan Abelson, Columnist, Barron’s

LAÏDI

INTERMARKET ANALYSIS

•

A gold-based approach to valuing the major
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CURRENCY
TRADING and
INTERMARKET

ANALYSIS
HOW TO PROFIT
FROM THE
SHIFTING
CURRENTS IN
GLOBAL MARKETS
“For anyone eager to get a ﬁx on what makes the currency markets tick, this book is a

C

be a distinct asset class in banks’ investment

and the theories underpinning it have been widely
explored, there has been little discussion regarding the
practical intermarket relationships shaping currencies
via interest rates, equities, and commodities
...
As head FX strategist at CMC Markets—
one of the world’s leading forex/commodity brokers—
he understands the forces shaping today’s currency
market and their interplay with interest rates, equities,
and commodities
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Following an innovative approach based on what still
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applying charts and case studies to intermarket
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perfect introduction
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ASHRAF LAÏDI
ASHRAF LAÏDI
FOREWARD BY RON INSANA

urrencies are becoming an integral part of

(continued on back flap)

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