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of a single theory of FX determination allows overshooting to occur on the influence of other markets. A shop-keeper in Lucerne will glibly comment that the dollar is down against the Swiss franc because oil is up. An amateur retail FX trader in Hong Kong will say it’s obvious that the S&P 500 and the FTSE 100 will follow the Shanghai Composite index down in a nerve-wracking big move, and a drop in global stock markets logically harms the dollar. Really? This is true only in the sense that greed and fear can easily jump asset boundaries. As for real-world fundamental connections, nearly everything posited about intermarket relationships is badly formulated, mistaken and often easily refuted.

      But note that professional traders and key players like hedge funds are required to behave as though they accept the cause-and-effect relationship of FX and other markets because this is how they earn a living. A trader may know perfectly well that a big change in the price of oil or gold has no fundamental relationship to currencies in any particular situation, but will trade as though it does because that’s the profitable strategy. This is one of the more vital of the insights into the FX market that we want to convey in this book – data proving intermarket correlations may be undeniable, but correlation is not causation and to assume intermarket relationships are valid and long-lasting can be dangerous.

      Finally, sometimes the FX market overshoots because a technical pattern is being completed. FX is always heavily influenced by chart-reading, more so than any other market. Traders use technical analysis because it is an effective tool to measure sentiment and reliably leads to profitable trading. Anyone with a bias against technical analysis will not fare well in FX.

      How do the reputational aspects of money affect FX trading and is it justified that the dollar is in perpetual crisis?

      Sentiment has many faces but can be boiled down to one concept – risk appetite or risk aversion. Preconceptions and bias toward nationalities is incorporated in the rolling risk appetite/risk aversion calculation. The euro, for example, has magic, and the dollar does not. The euro is able to withstand a major sovereign debt and banking crisis with less loss of value and less volatility than the history of currencies would suggest.

      In contrast, the dollar can’t get a break and is sold heavily on the slightest pretext, with bad economic news exaggerated and good news dismissed or undervalued. This is the fate of all reserve currencies, including the dollar, because to serve the reserve currency needs of the rest of the world, the reserve country always has to issue more currency than it needs for purely domestic uses. And yet the reserve currency is a safe haven in times of financial market panic.

      Decoding how the FX market really works

      Many economists and financial professionals view the foreign exchange market as the pinnacle of sophistication. FX rates embody all the important Big Picture Macro developments of the day as well as the hidden undercurrents of the international capital markets. The FX market is linked to core economic health, central bank monetary policies, various countries’ fiscal conditions, and trends in stocks and commodities. FX is the glamorous top of the heap.

      And yet the professional bank traders who actually move the market minute by minute and day by day are like any other traders. They rarely have PhDs in international economics and finance. They are not paid to have analytically correct opinions. Their sole job is to make a speculative profit for the employer, literally out of thin air. It is thin air they are trading with because banks, hedge funds and other big players do not allocate actual cash or collateral to trade FX – it’s all done on credit lines. Professional FX traders can be viewed as the biggest speculators on the planet, with the primary currency traders at each of the big banks, sovereign risk funds and hedge funds having a credit line stake of hundreds of millions of dollars.

      So which is it, pinnacle of high finance or grubby profit-seeking? It’s both. How, then, do we get FX prices that reflect all those high-level economic factors and links to governments and other markets? Well, we don’t. The reflection is like that in a fun-house mirror. Currencies do not equilibrate disparate conditions and imbalances, as economists theorise they should. Imbalances persist not for brief periods, but for decades. We see big exceptions to seemingly classic and timeless rules, like capital following the highest real rate of return and exiting a currency when returns fall. This is just one of the many strange and seemingly contradictory characteristics of the FX market that we seek to explain in this book.

      Our goal is to describe how the FX market works in practice and to demystify as many of these puzzles as we can. Together we have about 50 years of experience in the FX market as big-bank spot desk dealer, big bank corporate FX trader, market economist, technical analyst, risk manager, and wire service reporter/financial advisor. Between us, we know or have heard of just about everything, and are equipped to verify or to debunk much of it.

      Our purpose, however, is not to present a primer on FX. We assume that the reader already has a high level of knowledge about financial markets generally and a particular curiosity about the FX market. We can’t puncture every misleading or inaccurate idea about FX that has been published as fact in the past decade, but we can offer a perspective that is both true and useful.

      To help us do this, we use the overarching concept of risk appetite and its opposite side, risk aversion. Risk appetite is the only explanation that bridges the tangle of contradictory facts and theories about FX. For example, how can a crisis in Europe trigger an already overvalued Japanese yen to become stronger, even in the face of Japanese economic data that dictates the yen should be weaker? The answer lies in risk aversion inspiring Japanese investors to repatriate funds into the safe-haven home currency, the yen. The explanatory value of risk appetite/risk aversion is powerful, and much needed. Before we go further it is important to understand what risk aversion is and how it came to be used in analysis of the FX markets.

      Risk aversion

      Risk aversion is a concept arising from economists in the insurance industry (later applied with great efficacy in designing lotteries). Academic work on this area includes measuring and modelling such things as the effect on absolute and relative risk aversion of a change in wealth. For example, a rich man fears losing 0.01% of his wealth more than a poor man fears losing 10% of his, which is one of the great mysteries of the human brain. Following the Lehman debacle in the autumn of 2008, the use of the concept of risk aversion to explain FX market behaviour was quickly adopted. Application of the concept to financial markets and especially FX quickly went viral and became universal within weeks.

      In financial markets generally and the FX market in particular, we observe that players mostly act like the rich man – risk aversion starts out high and goes higher as a one-time specific threat to wealth appears. The Lehman Brothers bankruptcy was a spectacular example of a variable outside the usual scope of the FX market that became internal to the FX market through the transmission mechanism of short-term interest rates. The perception of excessive riskiness in the interbank lending market morphed in to a perception of excessive riskiness in the euro/dollar currency market. Risk aversion is what they have in common – it’s a force through which price actions are produced.

      As liquidity dried up and interbank lending tapered off to a trickle everywhere in the world, the US 4-week bank discount rate shifted from 1.92% at the beginning of June to 1.35% on 12 September – and 0.28% on 15 September, the date of the Lehman bankruptcy announcement. By year-end 2008, it was 0.11%. Yields fell all along the curve, too. The yield on the 10-year note was 4.324% on 13 June and dipped to 3.25% on 16 September. It bottomed near year-end at 2.038% on 18 December 2008. Around the same time, the euro fell from 1.5948 on 16 July 2008 to 1.2738 on 22 October 2008.

      The drop in return reflects a massive safe-haven inflow to the dollar that violates the usual rule that currency follows yield. In other words, if all other things are equal, we expect a currency to fall if its yield is falling, especially the after-inflation, real yield. In 2008, investors were happy to get return of capital and never mind return on capital. The Treasury’s report on capital flows bears out this thesis. The net capital flow to the US, including Treasuries, Agencies and equities, rose from $14.76 billion in August

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