Book Review

Does the trading world really need another book on the FX market? Clearly we thought so, since so much of what is written about the FX market is simplistic or just plain wrong. For example, FX is said to have a strong correlation with commodities, particularly oil and gold. The dollar is also said to be inversely correlated with the S&P. But sometimes neither relationship is present or if it?s present, it is the opposite of the conventional wisdom. Correlations work when they work and then they tend to fade. Similarly, there are press reports that state that sterling fell on release of some nugget of bad economic data, when in fact it fell because it failed to surpass a technical benchmark to the upside or because there were more sellers than buyers, period. If you can?t buy it, sell it.

FX is two wildly different things at once?the pinnacle of high finance and grubby profit-seeking. Economists model the factors that are supposed to determine a currency?s exchange rate, such as purchasing power parity and trade balances, but in practice, currencies evade the adjustments that would result in equilibrium–sometimes for weeks at a time and sometimes for decades. FX is different from other securities and asset classes, where cause-and-effect is usually a function of readily identified supply and demand factors. How do you discover supply and demand in FX when some 95% of the trades are done in secret and you have no volume statistics? In the interbank spot market, every trade is a private contract between the bank and the customer, and not reported. Hardly any of the major players, including hedge funds and sovereign wealth funds, disclose their positions. How do you guestimate the size of these flows?

Interbank traders, whose job it is to anticipate supply and demand from the big players, tend not to have an analytical framework. They don?t need it?they just have to anticipate how others will respond to news and events as they develop. In fact, we can say that technical analysis was adopted early on in FX specifically to help the rest of us to read the minds of interbank traders, since price action so often runs contrary to what economists would consider reasonable. In fact, the absence of benchmarks in FX is a serious drawback. In equities, you have ?fair value? and beta, or the degree to which a security is correlated with its market index. In currencies, estimates of fair value are an interesting curiosity and at times put forward by various analysts, but not a decisive driver.

One key driver in the currency area is central bank policy. Central banks and other government institutions affect stocks, bonds and commodities, too, of course, but in FX the response is faster and deeper. When former ECB chief Jean Claude Trichet complained about the high euro being ?brutal? to the real economy, the euro fell a hundred points in an hour. When Japan put in a new government in the fall of 2012, comments from the prime minister, economy minister and finance minister propelled the dollar/yen from ¥77 to ¥92 over the course of four months?and in the absence of any implemented policy change, and the policy change proposed having failed for the previous two decades. In sum, FX price moves are often infuriatingly perverse and seemingly irrational, and yet you can untangle it all, or mostly all, with the right understanding of the animal spirits affecting the market.

We have intermarket factors, economic factors, positioning factors, technical factors, and institutional factors. In FX, you never know which one will be dominant at any one point in time, and in any case, sometimes its takes specific conditions from two or three of these realms to establish a viable forecast. Even then, you could have the economic and institutional factors lined up one way only to run into a brick wall of the opposite technical picture.

In a sense, the FX analyst and trader is always juggling confirming or competing conditions from the deep and wide factor set. This is what we propose in The FX Matrix?evaluation of the directional bias from each category of influences, and with an eye always out for an Event or surprise from the non-standard or exogenous factors elsewhere in the world. A non-standard event that reverberated into FX was the Lehman collapse that infected FX via the loss of liquidity in the interbank money market. The Lehman contagion spread to oil, equities, real economies, and sovereign debt, showing us that one useful way to evaluate the FX factor set is by its effect on risk appetite and risk aversion. During the early stages of this crisis, for example, oil, note yields and equities crashed while the dollar was the beneficiary of safe-haven flows, a seeming vindication of the intermarket effect that is now the conventional wisdom. But we can find plenty of instances where the correlations do not hold, from which we deduce that intermarket correlations are most likely present during bouts of severe risk aversion.

For a few years now, the risk appetite model has worked to knit together the factors that influence FX rates, although not always in a neat and tidy way. Still, understanding that FX prices move on multiple conditions and those conditions can be at odds with one another is, we hope, an advance over single-cause explanations, which are never adequate. A corollary to the multiple-factor matrix approach is ?be careful what you read.? Nearly all of what is written and or said arises from too simple or incomplete a world-view. As Winston Churchill said, ?There is no sphere of human thought in which it is easier to show superficial cleverness and the appearance of superior wisdom than in discussing questions of currency and exchange.?