A billion dollars isn’t what it used to be.
Nelson Bunker Hunt (1926-)
I suspect I know what you are thinking. Here is this book about forex trading and, so far little, if anything, has been written about currencies. But as Master Po used to say “patience
grasshopper”! There is a reason and all will be revealed.
I have deliberately structured this book so that it starts with the three capital markets of commodities, bonds and equities as I wanted you to have a grounding in the key cross market relationships which drive the money flow from one market to another. And this would not have been possible had I started with the forex market and focused on it, in isolation.
Of course, the one currency which underpins every market and the global economy is the US dollar which we are now going to consider in detail.
It has always been my contention that if traders only understood the US dollar with all its ramifications in terms of the three analytical approaches, namely technical, fundamental and relational, their chances of success would increase exponentially. And even if you stopped reading at this point I believe the information in the preceding chapters will help you in your journey as a forex trader. However, I hope you will continue to the end!
Naturally, there is a great deal more, which I cover in the remainder of this book, but as I have written on several occasions already, and will probably continue to write several times more, you have to understand the US dollar. You have to take the US dollar as your starting point and in this chapter I am going to pull together some of the strands that I have touched on in some of the earlier chapters.
These strands include the relationship of the US dollar with commodities: the US dollar and gold; the US dollar and bonds; the US dollar as currency of first reserve and finally the US as the world’s largest economy.
But first a short history lesson, for which I make no apologies.
Whilst the modern foreign exchange market has its roots in the collapse of the Bretton Woods agreement of 1971, the currency market extends back to Elizabeth the First and 1560.
However, I am only going back as far as 1844.
Since 1844, there have been no less than three attempts to fix currency exchange rates using gold, the so called gold standard, all of which have ultimately failed. And, the obvious question is, why have a gold standard at all? To which a simple answer would be, it is a
mechanical attempt to control exchange rates.
The theory is it should introduce stability in the global economy, it makes managing inflation easier, whilst simultaneously generating a more controlled environment. One that is less susceptible to the boom and bust moves that are now commonplace.
However, the reasons each attempt has failed is simple enough. Eventually, one or more of the members who have adopted a gold standard begins to suffer, and whether from political or fiscal pressure are forced to take action in order to protect their own economy at the expense of the other participants.
A gold standard appears to be a simple solution to a complex problem, but is one that is always ultimately doomed to failure, as is a currency peg.
The first attempt was in 1844 when the United Kingdom adopted a gold standard which tied the value of notes issued by the Bank of England to gold, with the British Empire essentially adopting a gold standard as a result. Other countries followed suit, so that by 1900, the world had essentially adopted a gold standard.
Then in 1914 war broke out in Europe which led to inflation, due to the costs of war. This was followed by severe deflation in the wake of the Great Depression of 1929. This eventually led to the London conference in 1933, which saw the gold standard abandoned, with both the UK and US also being accused of trying to maintain an artificially low conversion rate for gold.
The abandonment of the gold standard led to a period of deflationary spirals, as one country attempted to devalue its currency relative to another in order to protect its economy.
Shades of what is currently happening in the forex market with many countries now actively engaged in the competitive devaluation of their home currency - aka the currency wars or the
‘race to the bottom’! So, as always there is nothing new in the world of economics and politics.
History, of course, teaches us nothing I’m afraid. The Great Depression and recovery was followed by the Second World War, which resulted in a massive depletion of the UK gold reserves which were used to fund the war effort.
This left the United Kingdom in no position to lead a revival in the gold standard. The natural successor was the United States, which emerged from the war with a huge manufacturing infrastructure.
With US output having doubled during the war it now led the world in production and exports.
In addition, the US now accounted for eighty percent of the world’s gold reserves. As a result, the US was now positioned as the strongest nation in the world, and uniquely positioned to benefit from international trade.
With weak trading members having been devastated by the war effort, it was no surprise that a
gold standard was suggested once again, and in July 1944 forty four nations met in the small town of Bretton Woods to formulate a new gold standard which was eventually agreed and ratified in 1946.
This was despite two of the strongest protests coming from the UK and France who preferred to follow a protectionist policy of trade embargoes and sanctions.
However, both were eventually forced to agree to trade concessions in return for US economic aid. This is one of the reasons why there is always an underlying tension between Europe (France), and the US.
The central premise of the new gold standard was for central banks to peg their currencies at an established and fixed value within plus or minus one percent of the benchmark US dollar, with the lynch pin of the system being gold. This was fixed at a rate of thirty five US dollars per ounce.
It was at this point in history that the US dollar became the world’s benchmark paper currency, and the currency of first reserve. A position it has held ever since.
As the currency of first reserve it is therefore considered a safe haven currency, as it underpins virtually every aspect of world trade. Bretton Woods also saw the establishment of the
International Monetary Fund or IMF. Its role was to arbitrate in disputes over the various pegs and par values of all the member currencies, as well to manage inflation by introducing
controls on those member countries who could not, or would not maintain their currency rates.
This second attempt at a gold standard lasted until the end of the 1960s, when several factors combined to undermine the US dollar and ultimately see the collapse of the Bretton Woods gold standard, with the eventual collapse happening in 1971.
The first factor was the Vietnam war, coupled with President Johnston’s social programme, which led to huge spending by the US government. And with tax revenues falling, this led to inflation and a reversal of the US balance of payments, resulting in a massive trade deficit.
Again does this sound familiar?
As a result, the US dollar became over valued against the currencies of Europe and Japan, both of whom were happy for this to continue. Their own weaker currencies would support their export markets, making goods cheaper for their overseas buyers.
We have seen the reverse of this in the past few years where a chronically weak and artificially deflated US dollar is causing problems around the world.
However, back to our history lesson. Here the US dollar had become overvalued and strong and by 1970 with inflation soaring and unsustainable debts, countries around the world were becoming increasingly nervous in holding US dollars. They also began to doubt the US’s ability to maintain the US dollar as the currency of first reserve.
This scenario suggested a possible run on gold of which the US only had approximately one third to cover all US dollar reserves overseas.
So, in 1971 Richard Nixon took the decision to close the “gold window” which was the facility whereby holders of US dollars could redeem them in return for gold.
This was the first crack in the Bretton Woods agreement which was finally abandoned two years later, with Germany having exited shortly after the Nixon announcement.
Bretton Woods was then replaced by the Smithsonian Agreement. In this agreement the dollar gold exchange rate was moved to $38 per ounce (instead of $35) and with a wider window of plus or minus 2.25 percent.
These agreements coexisted until 1973 when, with the continued advance in gold prices, the currency market was detached from gold and world currencies were finally left to free float and settle to a market price independent of any peg to gold.
What followed for the US was a decade of high inflation and a decline in its influence around the world.
Such was the birth of the modern forex market.
This is where we are today over forty years later and, whilst there have been no new attempts to peg currencies to the price of gold (despite many news articles to the contrary), there have been other attempts to control exchange rates in other ways.
The primary one was the EMS or European Monetary System, born out of the demise of the Bretton Woods agreement.
This was an attempt by the major European nations to protect their currencies by linking them together, and so prevent exchange rate fluctuations by plus or minus 2.25 percent, using the so called ERM or exchange rate mechanism.
This collapsed in grand style in September 1992, with the British pound eventually being
forced to withdraw, having come under consistent speculative attack. With George Soros being one of the principal architects of this demise in his BIG SHORT of the British pound.
The ERM mechanism was finally rendered redundant with the launch of the Euro as the single currency for EU member states, or for most of them at least!
I hope the above has, at least, given you a flavour of how the US dollar arrived at its unique position; why governments and banks try to introduce artificial controls to reduce currency fluctuations, and why all ultimately fail.
It also helps to explain why countries are so desperate to manage their exchange rates, either covertly or overtly which again is something I cover in more detail shortly. Indeed, this is also the reason many countries enter a currency peg, only to pay the penalty in the longer term.
In the last hundred years of currency exchange, the most dramatic change occurred on the 2nd January 2002, when the single European currency, the Euro was launched. In effect, ERM 2, replacing the old ERM system not with yet another cumbersome exchange rate peg, but this time with a real currency designed by the European powers with two simple objectives in mind.
First, to protect European member states from currency fluctuations within the Federal European state.
Second, to create a viable alternative to the US dollar as the currency of first reserve.
In other words, a politically created currency to shift the balance of power away from America and into Europe, and ultimately to create a currency for political union, as a precursor to the Euro taking on the role of currency of first reserve.
I do cover the Euro in more detail later in the book when we consider each individual currency in isolation, as we are doing here for the US dollar, but I wanted to introduce the concept of the Euro as a political currency.
As you will see the old animosity between Europe (France in particular) and the US resurfaces all the time, and indeed is ingrained into political statements both from the ECB and the EU.
We only need to look at how the currency is supported when under threat from the US dollar, but more on this later.
For now, let’s continue with the US dollar, and the period I would like to focus on, in
particular, is that of the last fifteen years, from the end of the last century to the present day.
This period covers some of the most interesting and cataclysmic events that we are ever likely to witness in the financial markets, and may have profoundly changed the role of the US dollar in the longer term as a result.
Naturally, only time will tell of course, as we rarely learn from history, and no doubt these events may be repeated once the memories fade and the cycle is repeated.
This period in history has been dominated by three major events.
First the Asian crisis which began in 1997, only to be followed by the dot com bubble bursting in 2001. Third, the near collapse of the financial world as banks and countries approached bankruptcy in 2008. But let’s start with the first of these, the Asian crisis.
The catalyst for this crisis was one simple event. The decision by Thailand’s authorities to decouple the Thai baht from the US dollar, and to allow the currency to free float in the market.
This simple decision resulted in a collapse in the value of the Thai baht, which quickly spread to other countries in South East Asia, causing currencies to decline rapidly, and triggering stock market falls as a result, with the contagion of fear spreading around the world eventually reaching Russia and parts of Europe.
Of course, whilst it was the act of removing the dollar peg that created the catalyst for the crisis, the problem had been building for some time, with the banks providing cheap money in a boom economy creating the inevitable bubble economy. This is so reminiscent of the sub prime débâcle of the last few years, and the Japanese 'lost decade' of several years earlier.
Something from which Japan has yet to recover almost twenty years later. What is deeply concerning is that the present crisis could last just as long.
As the Asian crisis unfolded, fear spread around the globe and investors increasingly turned to the US dollar as a safe haven. From 1999 to 2001 the dollar gained almost 25% against a basket of major currencies, as solid economic growth, coupled with soaring equity markets and relatively weak performance abroad provided the ultimate combination of safety and growth. This saw the dollar hit an all time high in 2001 before the next major event occurred, the bursting of the dot com bubble.
In this event stock markets around the world collapsed as realism and basic economic
principles finally held sway, and valueless companies, with absurd valuations, plunged. For the US dollar it was the start of a long slow decline, as the world slipped into recession between 2001 and 2002 and equity markets entered a four year bear cycle.
China meanwhile, sought to fill the void with its voracious appetite for commodities, and this proved to be a seminal period for global currencies. Whilst this was the start of the decline for the US dollar, it also marked the simultaneous emergence of the Euro which has consequently gained in strength ever since.
The falling dollar also triggered a super rally in commodities, which has extended for several years, with virtually every commodity breaking new highs on a regular basis.
But what triggered the start of this extended bearish trend for the US dollar which still
continues today? As is so often the case in the forex markets, it was self preservation that was the primary driver, led by the President of the day George Bush.
As we know a strong currency makes exports increasingly expensive, with companies and products become uncompetitive overseas which is a problem for all major exporting nations.
With the US dollar at a fifteen year high, the manufacturing sector in the US began calling on the government to act, and impose tariffs on its trading partners.
The government and the US treasury, therefore decided to adopt a policy of what can best be described as ‘benign neglect’. In other words, whilst publicly stating that a strong US dollar was good for the America, privately they were taking a very different approach.
And if you don’t believe that currency markets are subject to political manipulation, then please read the next section very carefully.
With the US dollar hitting an all time high against every other currency, in the spring of 2002, President Bush launched a trade war against steel producers overseas with two objectives in mind.
First, it was to secure a republican party victory in the Congressional elections due later in the year by winning over the key steel and manufacturing states. Second, to ensure a decline in the US dollar. This is always guaranteed, once trade sanctions were imposed.
The strategy worked, with the US dollar weakening, as selling the dollar became the de facto standard, with the Euro becoming increasingly stronger as a result, much to the delight of the Europeans.
Commodities benefited too, and we saw the start of another long bull trend, as the dollar continued lower, a trend that has continued virtually unabated ever since.
And so to the last event, which is perhaps be the most profound and devastating. Here we have experienced the perfect financial storm. As the debt fuelled bubble finally exploded on the financial world in 2008, with banks and countries collapsing under the weight of toxic debt.
Cheap loans made to high risk individuals with little or no prospect of repayment.
As economies ground to a halt, and recession and deflation loomed on the horizon,
governments and central banks were forced to act, taking interest rates close to zero in an effort to stimulate the economies out of recession.
The problem for the world’s largest economy however, was the dreaded D word, deflation, and in an attempt to prevent this the US treasury opted for two rounds of quantitative easing.
As we have already seen this has created a toxic bond market and yet further weakness in the US dollar as the currency markets have become awash with the American currency.
More subtly however, and as a direct result of this action, the US dollar has begun to lose its attraction as a safe haven currency, with investors increasingly looking elsewhere, with currencies such as the Swiss Franc, the Japanese yen and the Norwegian Krona providing alternative paper based homes for money flow. Indeed, this group of safe haven currencies has
More subtly however, and as a direct result of this action, the US dollar has begun to lose its attraction as a safe haven currency, with investors increasingly looking elsewhere, with currencies such as the Swiss Franc, the Japanese yen and the Norwegian Krona providing alternative paper based homes for money flow. Indeed, this group of safe haven currencies has