"The Accident Waiting to Happen"

Most people now accept that the U.S. dollar is an accident waiting to happen - all that is really in dispute is when and how and what the trigger is. The movements of the last couple of days have probably served to reinforce to U.S. dollar bulls the dangers of standing in the way of a crashing vehicle while U.S. dollar bears will have had their imaginations reignited as to the return possibilities especially if they are viewing things from a U.S. dollar base.

To be honest, the speed of the 2.3% move in the past five trading days is more shocking than the actual size of the move especially when there was no fundamental information that sparked it off (see above). After all, the U.S. dollar had been trading in a well-defined, if volatile, range since about May of 2006 and it has weathered some pretty negative news on the growth and housing fronts.

Inevitably we have been asked, "How far can this go?" by investors and to be honest it's difficult to give accurate answers mainly because there is no history on the euro to work from (it was only created seven years ago). But to help us you have to do a bit of lateral thinking because the area that is currently taking all of the strain (effectively importing the problems of the U.S.) is Europe while the yen is staying relatively untouched and is depreciating against the euro and sterling.

So ask this question - "where can sterling get to against the yen?" and then start calculating. Fortunately, there is a history of this (see second illustration) and a good first stopping off point going forwards for that relationship is between ¥250 and ¥260 (let's use ¥255 between friends) and keep the euro/sterling relationship stable at 1.48 which implies a yen/euro rate of ¥172. Now let's assume that the yen appreciates to, say,¥110 against the U.S. dollar in the process and you get a euro/US rate of 1.56 (¥172/¥110) which is a 19% movement.

Currency predictions are notoriously difficult to do and that's why here at Newton we really don't like providing spot forecasts as it makes you a hostage to fortune. There can be no guarantees even if you are right as to exactly when your predictions will be realised. But, as an illustration of the additive power of currency movements, there is no better example that exists right now than the triangular relationship between the U.S. dollar, European currencies and the yen.

When I was at university I was taught that if you ever wanted to find the mistake in any academic paper you look for the words "… and so it is obvious from this …" or " … if we assume …". If you want to destroy the conclusions of the author that is where the fault line lies - right there - every single time. And it must be accepted that there is lots of that in the preceding calculation. What could be wrong with it is:

At the same time it has to be acknowledged that there are reasons why this could be right;

Only time will tell as to the correctness of these ideas. We can write as much as we like, use clever analogies or mathematical models as much as we want, but in the end it will be the market that will decide who is right and who is wrong. There will be no hiding during the ensuing process but at this stage of the game it is better to open our minds to the possibilities of future currency movements and the opportunities they could offer rather than to stick our heads in the sand and deny it is happening. As we said before, we are somewhat suspicious of the moves in the past few days and have taken some profits by replacing some forward foreign exchange contracts with options to "bank" some of the performance created. The integrity of the anti-dollar policy is still in place although it has slightly calmed down. But, when and if it comes to it, the power of the mathematics illustrated here will be something we will be seizing upon to run a minimum in U.S. dollars going forwards.