Its all Relative
27 April 2009
Sean Russo
A QUARTER of a century ago I started paying interest to foreign exchange markets in a reasonably serious manner. Prior to that all I knew was if you went to America you got more money (and things were cheaper) and if you went to New Zealand you got less money (and everything except dairy products was more expensive). How the world changes! It’s an interesting reminder of the longer term impact of “dirty floats”: think Yuan.
As a young trader trying to get my head around currencies, their interrelationships and hopefully their future price paths I decided I needed a framework of my own. I pretty quickly figured out economists were only right occasionally and only ever in the long run, whereas I was paid monthly.
I initially developed a model I will refer to for politeness as the “Buckets of Manure Model”. My basic starting point was that all fiat currencies are fatally flawed. Over 500 previously recognised fiat currencies had disappeared over the previous three centuries and the average age of the existing currencies we were trying to trade was less than three decades. This was reinforced by the picture we had all seen at high school of the German man with the wheelbarrow full of Reichsmark going off to buy a loaf of bread. That anybody would pay anything for a loaf of German Pumpernickel or Rye surprised me; to be willing to part with a wheel barrow full of the folding stuff made me realise how worthless that money in the barrow was. Our kids will hold similar images from Zimbabwe.
Back to the manure. My theory was all currencies are basically a bucket of manure, all that differentiates them is the size of the bucket and the smell. Using this theory I figured all I would need to do was determine a way to recognise earlier than most when a bucket was going to become less smelly or at least group together those which were going to smell the least. Then as the general market got whiff of the change they would migrate to those buckets which should improve their relative worth as they cycled out of smelly to less smelly (what some might call the manure exchange rate) and I would make money.
I also discovered that what often makes a bucket smell less offensive is the self propagation rate - ie the amount of additional manure that just appears in the bucket (what others call interest), unless of course the self propagation rate got too high. As most manure bucket managers (central bankers and politicians) know it’s a delicate balance to make your bucket smell just right.
The really important issue I did come to learn as we had various manure crises was almost regardless of smell the bigger the bucket the better; when it comes to manure, liquidity, pardon the pun, is all important.
Standing back I realised that I was reducing the world financial markets to a big game of pass the parcel (or bucket in this case) which seemed a bit flippant for someone of an age that generally takes itself too seriously. Anyway, my theory still relied on me to be able to identify which buckets were going to improve their bouquet before anyone else did. I needed a new framework.
Looking around and listening to the older traders one of the theories of the day was if oil was going up sell the Yen and buy Sterling. Why? Japan was an oil importer and consumer and England in the days of North Sea oil was a net exporter. So being long Sterling Yen gave you a yielding oil proxy. It made perfect sense except it still relied on you being able to predict which way the oil price was going! The Currency as Commodity Proxy Theory. I felt I was closer but now I needed a model for predicting commodities.
By this time equity markets were all the rage. Of course, why not think of currencies as the share price of a country and the country as a conglomerate of its major industries? The bond rate as its dividend. The Currency as National Equity Theory was born. I was close to discovering the holy grail of currency trading and I still wasn’t out of my third decade. What had all these old coots been doing? I was on the way to being a Master of the Universe (which was no mean feat because if I think about it I don’t think Tom Wolfe had even coined the phrase yet)! All I had to do was analyse the major industries of each country rank their importance and relative prospects, adjust for population, discount for twilight industries, scale the impact of the predilections of the ruling elite and consider the attraction of the bond rate. Then I could rank all countries and sell the currencies of the bottom half of the list against the currencies of the top half of the list. The problem I discovered was I was back relying on economists and my boss still wasn’t interested in giving me a three-year contract with guaranteed bonuses (they were still a decade away)!
I was about to throw in the towel when I discovered charts and moving averages. These were the days before PCs on the dealing desk and we updated our charts every day with a pencil, point and figure charts, bar charts and then candlestick charts (a Japanese invention dating back to the 17th century when they were developed by rice traders – how many currencies and economic theories have lasted that long?).
Charts gave me a perspective I had been seeking and when my finance lecturers and my economist colleagues ridiculed charting as “Self Fulfilling Prophecy” I loved them even more. To look at a chart is to look at the record of action of all the real players, not the opinions of politicians or non-players like brokers, forecasters and academics and cab drivers. Moving averages help to take out the day-to-day noise and simplify the trend. If I had to choose only one it would be the 200-day moving average (more on that in the weeks ahead).
Let me be clear; I am not talking about looking for head and shoulders, double bottoms, triple tops, pennants, muffin tops, wedges or flags. I am just talking about looking at the picture the chart is conveying to you about the action that is occurring as opposed to that which is reported, anticipated or predicted. A good case in point is watching for a market that everyone says must fall based on whatever popular theory they are applying while the chart records its progress in the opposite direction or vice versa. Follow the money, not the commentators - there a few beauties at the moment.
Whatever chart type you choose (or theory you think is preferable) currencies are all still buckets of manure; that much I do know. Don’t get wedded to any of them and remember when they are all smelly it is all relative and ironically it's highly likely the biggest bucket will be one most sought after.