001

Table of Contents
 
Title Page
Copyright Page
Dedication
Acknowledgements
Introduction
Fundamental Analysis
Positioning Analysis
Technical Analysis
 
PART I - Fundamental Analysis
 
Chapter 1 - Purchasing Power Parity
 
Law of One Price
Purchasing Power Parity
Is the Dollar Overvalued?
 
Chapter 2 - Real Exchange Rates and the External Balance
 
Productivity Shocks and the Long-Run Equilibrium Exchange Rate
Terms of Trade and Exchange Rates
Fiscal Changes and the Long-Run Real Equilibrium Exchange Rate
International Investment and Exchange Rates
 
Chapter 3 - Exchange-Rate Determination over the Medium Term Parity ...
 
Parity Conditions
 
Chapter 4 - Fair-Value Regressions
 
Long-Term Fair-Value Regression for EUR/USD
Long-Term Fair-Value Regression for USD/CAD
Long-Term Fair-Value Regression for AUD/USD
Weekly Fair-Value Regressions
Daily Fair-Value Regressions
Conclusion
 
PART II - Market Sentiment and Positioning
Chapter 5 - Futures Non-Commercial Positioning
 
Which Measures for Position and Price Action to Use?
EUR/USD and CFTC Non-Commercial Positions
GBP/USD and CFTC Non-Commercial Positions
USD/CHF and CFTC Non-Commercial Positions
USD/JPY and CFTC Non-Commercial Positions
USD/CAD and CFTC Non-Commercial Positions
AUD/USD and CFTC Non-Commercial Positions
NZD/USD and CFTC Non-Commercial Positions
Finding the Data: Setting Up CIXs in Bloomberg
Conclusion
 
Chapter 6 - Risk Reversals
 
Analysis of Correlation with Price Action
EUR/USD and Risk Reversals
GBP/USD and Risk Reversals
USD/CHF and Risk Reversals
USD/JPY and Risk Reversals
USD/CAD and Risk Reversals
AUD/USD and Risk Reversals
NZD/USD and Risk Reversals
Conclusion
 
PART III - Technical Analysis
Chapter 7 - Trend-Following Indicators
 
Moving Averages
Parabolic SAR (Stop and Reverse)
Moving-Average Convergence/ Divergence (MACD) Indicator
Conclusion
 
Chapter 8 - Oscillators
 
Relative Strength Index (RSI)
Findings from RSI Analysis
Bollinger Bands
Slow Stochastics
Conclusion
 
Chapter 9 - Technical Pattern Recognition
 
Fibonacci Ratios/Levels
Head-and-Shoulders Patterns
Channels
Multiple Tops/Bottoms and Triangles/Wedges
Japanese Candlestick Patterns
Conclusion
 
Case Studies
CONCLUSION
INDEX
ABOUT THE AUTHORS
ABOUT BLOOMBERG

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001

This book is dedicated first to my wife, Melissa, and my children, Alexis and Joseph, who have supported me during this effort; second, to Don Alexander and Robert Sinche, who provided solid and steady mentorship; and third, to all who embark on the quest for the Holy Grail of currency valuation.
—T. J. M.
 
 
 
 
 
 
 
This book is dedicated to my wife, Amanda Jefferis: a woman of extraordinary intelligence, sweetness, and grace without whom life would be far less meaningful.
—J. B.

ACKNOWLEDGMENTS
I’d like to acknowledge the support of my wife, Melissa, and children, Alexis and Joseph, who put up with numerous lost weekends and cancelled and delayed plans. From a professional perspective, this book would not have been possible without Don Alexander, who gave me my first shot on Wall Street and provided me with the framework by which to analyze long-term currency trends. Bob Sinche, my manager at Citigroup’s institutional foreign-exchange research group, provided a tireless example of leadership and multifaceted analysis of foreign-exchange valuation and trading opportunities. I’d also like to thank the numerous professionals I’ve had the pleasure of meeting and discussing Forex with over the years. Finally, special thanks to Stephen Isaacs of Bloomberg for his editorial skills in guiding me through the process of putting years of thoughts and experience into some semblance of organized layout.
—T. J. M.
 
I would like to acknowledge the support of my father, Herman, and my mother, Donna, and thank my brothers Jason and James and my sister Rebecca, and her husband, A. J., for their love and encouragement. On a professional level, Robert Since, Ryan Sweet, Aaron Smith, Chris Cornell, Nathan Topper, and Michael Bratus have all provided valuable insight during the writing of this text. Finally, I would like to thank our editor, Stephen Isaacs, whose editorial skills made a complex and time-consuming effort so much easier than it should have been.
—J. B.

INTRODUCTION
How far will the dollar adjust? Within the context of a $3-trillion-a-day foreign-exchange market, the very question of the basic value of the greenback is perhaps the single biggest day-to-day issue in the global economy. Given the recent turbulence experienced by the global economy, the size of the U.S. current account deficit, the rate of consumption in China, and the structural impediments to growth in the European Union, the fundamental question of the adjustment of the dollar has become more—not less—important in the basic functioning of the global economy.
An economist can primarily focus on how larger macroeconomic changes will affect the value of the euro/dollar in the long run. Yet the larger macroeconomic questions that may affect the valuation of a currency pair over the long run may not be so useful in determining the fair value of a pair over the course of weeks or days, and almost never in the course of a single trading session. Portfolio managers and investors with position horizons of days and weeks cannot wait for long-term theory to “kick in,” and traders must instantaneously digest news, economic data releases, and trade flows. A currency strategist interacts with all three types of market participants both as a consumer of those groups’ information and as a provider of information to those groups. The range of both inputs and demands requires the application of a variety of methods by which to determine the value of the dollar.
Unlike many texts on foreign-exchange analytics, this text will not present one overarching methodology as “the way” to determine fair currency values. Rather, our approach, which relies on a multidisciplinary examination, provides an analytical framework for institutional analysts to utilize in making successful investment decisions regarding the currencies of major countries. Rather than presenting the disparate disciplines that are employed to make currency decisions in separate vacuums, this book recognizes that different perspectives take on key relevance in markets under varying conditions, and therefore, that the best investment decisions are based on inputs from the full spectrum of considerations.
Our analytical paradigm consists of three main groupings: fundamental, positioning, and technical. By employing this analytical framework, we believe that this text provides an accurate and realistic look into how foreign-exchange analysts, economists, investors, and traders actually seek to put together profitable investment and trading strategies and mitigate risk in the open global economy.
The foundation and starting point of our framework consists of fundamental analyses to provide macroeconomic and cross-asset perspectives. The second grouping consists of positioning analysis, which attempts to identify extremes in positioning—and so potential turns in market sentiment/direction. Finally, technical analysis provides even more precise price action “triggers” for investment and trading decisions.
Figure I.1 Comprehensive Currency Analysis Framework
002

Fundamental Analysis

We begin the analysis of any currency using fundamental variables. The very broadest considerations involve purchasing power parity (PPP) and real effective exchange rate (REER) analysis. These frameworks permit an analyst to establish a contextual perspective regarding the “value” of a particular currency. These analytical tools are well suited to long-run exchange-rate determination and are useful to buy-side firms that practice buy-and-hold strategies or global firms that are engaged in long-term planning in a dynamic foreign-exchange environment.
However, the limits of the long-run approach favored by academics and some buy-side institutions are quite observable. Long-run valuations are so broad in scope, they often provide only modest value to traders or risk managers who require more detailed analysis to determine value and potential price action over a more actionable time horizon.
A more precise valuation of a currency’s fundamental fair value for the medium term can be obtained using regression analysis based on monthly economic and financial data. Regressing the currency against financial data using fifty-two weeks of weekly data further refines this estimate. Finally, recognizing that different fundamental considerations can dominate price action over shorter time horizons, one can employ regression analysis of daily price action using sixty-day time horizons to obtain short-term valuations.

Positioning Analysis

Whereas the above methods provide a robust analysis using macroeconomic and cross-asset underpinnings to explain valuations and price action, they do not always lead to profitable decisions. Too often, a purely fundamental approach ignores the psychological aspect of market behavior. According to an old, wise adage, “the markets can stay irrational longer than an investor can stay solvent.” Thus, we incorporate a second level of analysis based on measures of market positioning that allows market actors and risk managers to identify extremes and potential changes in the direction of the market.
Two publicly available measures of market sentiment are the positions reported to the U.S. Commodity Futures Trading Commission (CFTC) by non-commercial traders (sometimes referred to as speculators) and options risk reversals. The CFTC positions are collected by the CFTC once per week on Tuesdays and released on Fridays. Extremes in the positions of non-commercial traders relative to the CFTC positions in recent months allow an analyst to identify when at least one segment of the trading/investing community has not only likely exhausted its ability to contribute further to a price trend, but also could be more likely to begin trading the other way in a market, precipitating a reversal in price action. The drawback of the data is that it is published late on Friday afternoons in the United States when liquidity is low, and that it is three days old when released.
A timelier positioning indicator, although one measuring a different segment of the market, is the risk-reversal skew in the options market (risk reversals). Risk reversals measure the difference in premium for puts versus calls on a particular currency. Extreme readings suggest that options traders are “off balance” in their view regarding future price action, which suggests an increased potential for a reversal in price action. Whereas shifts in both the CFTC and risk reversals tend to correspond to shifts in price action relative to trend, they are frustratingly ambiguous in providing concrete entry or exit levels, and this leads us to the third section of our currency analysis: technical analysis.

Technical Analysis

Detractors liken technical analysis to reading tea leaves. Technical analysts retort that price action “says it all” regarding what is going on in the market and scoff at how often “fundamentalists” obstinately hold a position when price action is screaming that one’s view of how the world works “just isn’t so.” We remain firmly neutral in this bitter debate, noting only from a pragmatic perspective that if enough market participants decide that price action in regards to a channel support, a head-and-shoulder neckline, or a 76.4 percent Fibonacci retracement is important, then it probably is important.
Consequently, we are not looking to establish “black box” technical trading models, but to offer a framework that incorporates changing market sentiment and an appreciation of which specific levels or patterns could be decisive in influencing behavior and price action. In viewing the foreign-exchange markets through a multidimensional prism, a decision maker can make more informed—and profitable—decisions.

PART I
Fundamental Analysis
As we write this in the spring of 2009, the near collapse of the global financial system in 2008 has ushered in the most severe economic downturn since the Great Depression. Dislocation in financial markets caused by the breakdown of monetary discipline, lack of financial regulation, and imprudent lending standards by financials has unleashed a sea of volatility in the global market for foreign exchange.
This market, with a volume of close to three trillion dollars per day, has perhaps experienced its greatest volatility of any time during the era of floating exchange rates. Between January 2007 and February 2009, the exchange rate of the euro/dollar (EUR/ USD) has moved from a position of overvaluation to undervaluation and back. The yen has seen highs not experienced since 1995, and the stabilization of emerging market currencies such as Mexico’s has been lost amid 10 percent declines in valuation in a single day against the dollar.
From December 2008 to February 2009, market sentiment swung from expecting the long-term secular decline of the dollar to the greenback threatening to drive towards parity with the euro. A few short months later, the new quantitative easing policy of the U.S. Federal Reserve, which provides an outsized risk to the long-term inflation prospects of the United States, has swung the market back in the other direction. The euro once again, as of June 2009, appears to be ascendant and the dollar in decline. Unless, of course, the European Central Bank adopts its own version of quantitative easing that will engender another period of volatility in currency markets. Of course, the Chinese call for the adoption of a new global reserve currency, due to the problems in the advanced economies, carries with it the possibility to reorder the global economic landscape.
Under such conditions, the attempt by economists and currency strategists to construct short-term trading strategies or corporate actors to manage foreign-exchange risk is fraught with extreme difficulty. But the advent of a global economy that demands the exchange of currency on a continuous basis does not provide such a luxury.
Yet what on one hand may seem to be a curse, on the other offers tremendous opportunity. For the seasoned foreign-exchange trader this is a difficult but potentially lucrative environment in which to put into practice the ideas, tactics, and strategies at the heart of this text.
So, under such conditions, how does one derive the fair value of the dollar versus the other major currencies? Where should one start, given the significant disturbances in the foreign-exchange markets observed over the past forty years and the probability of further volatility ahead? What value does fundamental analysis have for the currency analyst in such an environment? The first section of this text intends to provide an answer to those potent questions by presenting the theoretical backbone of fundamental analysis, which still plays a significant role in assessing fair exchange-rate values.

1
Purchasing Power Parity
Purchasing power parity (PPP): three words that are sure to warm the heart of any currency economist. But that same concept is certain to cast a glaze over the eyes of most observers of foreign-exchange markets and send a surge of skepticism up the spines of experienced foreign-exchange traders. Yet, the value of such a tried-and-true method of deriving foreign-exchange rates has not diminished.
The Organization for Economic Cooperation and Development (OECD) defines PPP as the rate of currency conversion that equalizes the purchasing power of different currencies by eliminating the differences in price levels between countries. Put a bit more simply, PPP is a method through which one can evaluate how changes in the absolute or relative price level drive changes in the underlying exchange rate between two currencies. This chapter discusses the relative usefulness and shortcomings of employing PPP in foreign-exchange analysis.

Law of One Price

To obtain a solid grasp of the concept of PPP, it is necessary to first understand the law of one price. The law of price reflects the idea that if two firms in different countries produce identical goods, assuming that transportation costs are stable and trade barriers low, then the cost of that good should be the same throughout the global system. Thus, if American-made desktop computers cost $90.00 per unit in the United States, and an identical Japanese computer costs 8,100 yen in Japan, the exchange rate must be 90 yen per dollar ($0.011 per yen). If this condition holds, then one U.S. computer must sell for 8,100 yen in Japan, and one Japanese desktop must sell for $90 in America.
If the exchange rate were to increase to 180 yen to the dollar, then the cost of a Japanese desktop computer would be $45.00 per unit, and the price of the same American product in Japan would be 16,200 yen. Thus, the cost of a Japanese computer would be reduced by roughly half, due to the change in the relative exchange rate, increasing the purchasing power of all those holding dollars. (See Figure 1.1.)
In theory, due to Japanese computers being relatively cheap, demand for these computers in both America and Japan should increase and demand for U.S. computers should fall to close to zero. Since U.S. computers are more expensive than the identical machine in Japan, the net impact is that the resulting increase in supply of U.S. computers will be reduced as the exchange rate falls back to $90.00, which would bring the price of identical computers in Japan and the U.S. back into alignment.

Purchasing Power Parity

Economists often use PPP to ascertain the fundamental value in foreign-exchange markets between two currencies. It asserts that the exchange rate between any two currencies will adjust in light of changes in the price levels of the two home countries of the units of exchange. At its core, PPP is an attempt to explain the relationship between the prices of tradable goods and the exchange rate. Thus, the theory of PPP states that the long-run equilibrium value (E) of a currency is primarily determined by the ratio of domestic prices (P) in the home country relative to those abroad (P*).
(1.1)
003
Figure 1.1 Dollar/Yen Exchange Rates
Source: Federal Reserve Board.
004
Using this framework, the theory of PPP would suggest that the long-term equilibrium value of the dollar/yen rate ($/¥) would be determined by the ratio of the price level in the United States (PUS) relative to the price level in Japan (PJ).
$/ ¥ = PJ/PUS
According to PPP theory, one can fairly derive the fundamental value of a currency by estimating what an identical product can be purchased for at home and abroad. In our example, the relative cost of an identical computer in the United States should be exactly the same as it is in Japan.
However, theory does not always approximate reality. Should exchange rates overshoot or undershoot equilibrium PPP levels, opportunities for individuals to engage in arbitrage would ensue. For example, if computers in the United States due to a change in the exchange rate were to become cheaper than those in Japan, opportunistic individuals and firms could then buy low in the United States, sell high in Japan, and capitalize on the relative change in the exchange rate. Thus, capital and goods would flow between the two countries until such a time (no doubt a very short period of time) when the cost of purchasing identical computers in both the United States and Japan falls back into equilibrium.

Variation on a Theme

Inside the investment community most economists and foreign-exchange analysts use some variation of purchasing power parity to derive what they consider to be a reliable and robust estimate of the fair value of exchange rates. Should exchange rates of a currency pair deviate too far from PPP, many if not most analysts would expect over the long term that the pair would move back towards equilibrium.
Yet, as Keynes stated, “in the long run, we shall all be dead.” Thus, it is of little surprise to observe that there is more than one version of PPP and several factors that affect exchange rates in the long run.

Absolute Purchasing Power

The theoretical underpinning of PPP rests on a set of assumptions. Thus, by conveniently assuming away differences in transportation costs, transactions costs, restrictions in trade, and taxes, it is possible that tradable goods that are identical should be available at the same price anywhere in the global economy after accounting for exchange rates. This is often referred to as the absolute version of PPP simply because it deals with an absolute price level. This is easily understood by the following: Let S indicate the U.S. dollar/yen exchange rate, $/ ¥. Then let P signify the price level in the United States and P* denote the price level in Japan. Thus, we can express the absolute version of PPP as
(1.2)
005
Put a bit more simply, the price level of the domestic currency should be absolutely equal to the foreign price level multiplied by the spot exchange rate. This version of PPP can be applied to all identical tradable goods and services. Thus, P is a representation of a wide range of goods, but not a single good. This strongly suggests that the activity of arbitrage plays a critical role as a catalyst for the convergence of prices implied by the law of one price that lies at the heart of the idea of absolute purchasing power parity.

Shortcomings in Absolute Purchasing Power Parity

However conceptually attractive the absolute variant of PPP is, there are several shortcomings to this potent explanation of long-term exchange rates. Paramount among these shortcomings is the fact that as a short-term predictor of exchange-rate movements, PPP does not have the best record. How could a basic theoretic explanation that is used in just about every introductory and intermediate economic textbook be so deficient? The answer is located in the basic assumptions behind absolute PPP.
First, the basic assumptions of no differences in transportation costs in an era of volatile energy costs and the variation in energy subsidies from country to country cast considerable doubt upon this idea.
Second, the variations in tariffs and taxes from country to country are quite dramatic, and these factors play a significant role in shaping the incentives to produce and the relative costs of goods.
Simplification of reality through the use of such assumptions is quite useful for the development of theory and the models to support it. Yet, for the spot trader or forward-desk analyst, theoretical elegance or long-term efficacy is of little use in formulating day-to-day or near-term strategies.

Relative Purchasing Power

Due to the limitations of the absolute version of PPP, some analysts rely on a bounded version that focuses on price changes as opposed to a singular emphasis on absolute price levels. This is best understood by the following. Let %Δ denote the percentage change of a variable, S the spot rate, P the price level, and P* the foreign price level. Thus, the concept of relative purchasing power can best be expressed by the following:
(1.3)
006
This implies that a change in the exchange rate equals the difference in percentage change in prices between the two economies. Foreign exchange-rate analysts would then focus on the public rate of inflation. Keeping within the framework of our earlier example, then let Π be the rate of inflation in the United States and Π* be the rate of inflation in Japan. Then if a foreign-exchange analyst were interested in seeking to estimate the possible appreciation or depreciation of the dollar/yen spot rate, he would investigate the differences between the two countries’ inflation rates. Thus, we can rewrite the expression for relative PPP as
(1.4)
007
For example, assume that the nominal exchange rate for the USD/UK pound ($/£) in a given base year was $1.50. Then assume that the price of goods and services in the United States had risen by 8 percent, and the cost of those same goods and services in the United Kingdom had risen by 4 percent. Then the PPP spot rate would be $1.50/£1 × 1.08/1.04 = $1.557/£1. The nominal exchange rate of $1.557/£1 can be used to establish a PPP comparison to the base period. Thus, a nominal exchange rate greater than $1.557/£1 implies that the British pound is overvalued, and a nominal exchange rate less than $1.557/£1 suggests that the U.S. dollar is overvalued.

PPP and Exchange-Rate Analysis

Without a doubt, PPP is a useful method in the toolbox of any economist. Over the long run, PPP can provide a fairly effective tool for predicting exchange rates. Yet, like many theoretical propositions in the dismal science, the reliability of either version of PPP is a function of the conditions under which it is used. For example, if one were to observe a monetary-induced shock to an equilibrium position, PPP will tend to hold up very well. Why? Because, under the quantity theory of money, the supply of money relative to the demand for money affects the price level of a currency. Using PPP theory, one would find that currency values would adjust as prices on an international basis adjust. If one assumes that the supply of money determines the price level, changes in relative prices would then act as the primary catalyst for a change in the exchange rate. Under such conditions, it is fair to conclude that a change in monetary policy can facilitate a change in exchange rates and does provide a fairly convincing validation of the theory of PPP. (See Figure 1.2.)
However, not all shocks to a general equilibrium position are monetarily induced. Real factors such as changes to the terms of trade, the discovery of scarce resources, productivity shocks, and changes in the rate of growth will often alter the current account balance of a country and have an impact on exchange rates. A change in the underlying long-term trend in the current account will often occur outside of any change in the relative price levels. Such a change in the long-term trend inside a country’s current account will often stimulate a change in exchange rates to reflect a positive or negative change in the current account balance.
Figure 1.2 Japanese Yen Purchasing Power Parity vs. Spot Rate
Source: Bloomberg.
008
Thus, a change in real factors such as a productivity shock can cause a fundamental reorientation of how the market perceives the fair value of an exchange rate that is not accompanied by a change in the underlying price level. This strongly implies that an equilibrium exchange rate can deviate from that which would be predicted by the theoretical propositions put forward by PPP and does suggest that there are a range of factors and methods that can be used to explain changes in exchange rates. More pertinently, the absolutely unbounded version of PPP may not provide a satisfactory explanation of exchange rates under a wide range of conditions.

Calculating PPP

One of the major issues surrounding the use of PPP to determine the fair value of exchange rate is that there are an extraordinarily large number of ways to calculate it. The method that one chooses may alter the outcome that one derives. For the foreign-exchange analyst, this is a particularly problematic issue since choosing a method to calculate PPP will determine the extent to which a currency is overvalued or undervalued. Thus, whether one uses a particular price level, price deflator, or price index will provide the framework in which an analyst may take a position in the market on a short- or long-term basis. Thus, whether one chooses to employ the consumer price index (CPI), producer price index, or personal consumption expenditure deflator in an attempt to derive the correct value of a currency pair is crucial and will cause variation in outcomes.
For example, if one were to choose the consumer price index between the United States and the European Union as a basis to derive the fair value of the EUR/USD, one would run into two problems. First, the composition of relative price indexes varies between countries and regions. The consumer price index inside the United States is quite different from that of the European Union. In the U.S. CPI, the cost of shelter is given an extraordinarily large weight of over 40 percent in the index, whereas in the European Union, it is given far less. The weightings inside the relative indexes ref lect the different tastes and preferences of the respective consumers inside each economy. As such, there is no optimal benchmark to compare relative prices across international boundaries for a foreign-exchange strategist.
Second, both the absolute and relative version of PPP depend on the assumption of tradable and identical goods. It is without a doubt that within the design of price indexes, non-tradable goods make their way into the constructs and affect the relative price level. Thus, one can lean toward using wholesale price indexes and producer price indexes that are composed of tradable goods, but that too is fraught with risks. An overdependence on the use of such indexes presents problems in that a prediction of an exchange rate would be of dubious value, since a fair value estimate based on purely tradable goods could conceivably constitute a tautology and provide a misleading and costly set of erroneous information for a trading operation.
Finally, there are always issues surrounding the choice of a base year for the construction of an index or providing a profitable PPP calculation. One of the primary assumptions behind PPP is that a change in an exchange rate can be traced to a change in the price level that is based on the selection of a carefully crafted and appropriate base year. Therein lies the problem. The choice of a base year can decisively influence the assessment of whether a currency is fairly valued.
It is typical for analysts to choose a base year that corresponds with major structural changes in the international economic system when an index could plausibly be constructed to ref lect a zero current account balance between two countries. Such years as 1973, when the United States abrogated the gold standard, or perhaps the last year the U.S. current account was in balance, 1980, are often chosen by savvy analysts as base years to construct a meaningful index.
In truth, just about any choice of a base year can be criticized as arbitrary. There is some truthfulness to this criticism due to the difficulties of accurately estimating the long-run value of an exchange rate in any given year over the long term.
So, how does one solve this problem? One useful approach to solving the base-year problem is to construct the long-run moving average of an exchange rate. Given the volatility of exchange rates during the era of floating rates, any analyst worth his salt can attest to the fact that there are sustained and persistent deviations away from the long-run equilibrium path as would be predicted by PPP. Thus, the construction of a moving average around the long-term equilibrium value that would be predicted by PPP is a useful way to predict exchange-rate movements.
Should there be a structural change driven by a productivity shock or a change in real factors, this construct may not provide a satisfactory valuation of an exchange rate. Under such conditions, the construction of the long-run moving average may tend to undershoot the true value of the exchange rate, and it may be more useful to construct a weighted moving average of past trends in the underlying exchange rate. Whatever the case, it is paramount that a currency economist or a foreign-exchange analyst be cognizant of the change in the monetary environment and real factors in order to construct profitable trading strategies or manage risk in the foreign-exchange market.
A second way of dealing with problems associated with choosing a base year is to use the constructs of the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD). The recent updating of PPP by the International Comparison Program is benchmarked to the year 2005. This update, which is used to derive estimates of PPP, sought to take into account price differences between countries, and permit comparisons of market size, structural differences between and among economies, and the purchasing power of national currencies. The update brings together the efforts of the ICP and the OECD PPP program, provides estimates of GDP per capita for 146 countries, and constructs a price level index that intends to demonstrate which economies are the most inexpensive and expensive using foreign-exchange rates. Although this effort has proven somewhat controversial, the survey conducted during 2005 collected prices for more than one thousand goods and services, according to the ICP, using innovative data validation tools to improve the quality of the data.
Figure 1.3 Euro and USD Purchasing Power Parity vs. Spot Rate
Source: Bloomberg.
009

PPP—An Empirical Assessment

There is a heavy volume of academic literature that empirically tests the basic theoretical propositions behind PPP. There is a preponderance of evidence that implies that over the long term exchange rates do tend to converge toward their PPP values, albeit with sustained and persistent deviations in the short and medium term. (See Figure 1.3.)
The major question that most analysts ask is how long these deviations from the long-term trend take. The empirical literature strongly suggests that the rate of convergence is somewhat slow and it can take up to five years before a deviation from the longer-term underlying trend can evaporate.

Is the Dollar Overvalued?

There has been much ink spent on the question of whether the greenback is overvalued. Indeed during the period from July 2002 to August 2008, one did see a fairly strong secular downward trend in the value of the dollar. Many analysts attributed this to the combination of the persistent imbalances in the global economy due to overspending on the part of American consumers and oversaving on the part of Chinese consumers. (See Figure 1.4.) Others attribute the weak dollar to the accommodative monetary stance of the Alan Greenspan and Ben Bernanke Fed regimes during that time.
Figure 1.4 G10 Purchasing Power Parities
Source: Bloomberg.
010
However, during the most intense portion of the global financial and banking crisis of 2007 to 2009—between October and December of 2008—the dollar became a safe haven. Thus, the market observed a sharp correction upward in the value of the dollar vis-à-vis the euro. (See Figure 1.5.)
The synchronized global recession that became quite apparent in late 2008 was the primary catalyst behind a severe bout of risk aversion among global investors. Under the extreme conditions wrought by a global banking crisis, the relative safety of U.S. Treasury instruments caused euros, pesos, and Swiss francs to be exchanged for U.S. dollars.
Figure 1.5 Euro/USD Exchange Rate
Source: Federal Reserve Board.
011
This behavior was primarily a function of the long-standing role the dollar has played as the reserve currency of the global economy. Another part represented the inertia of traders, who in a crisis fall back on the relative safety of the dollar.

Quantitative Easing

As the global economic crisis deepened, global central banks engaged in quantitative easing. Quantitative easing involves a central bank forgoing its independence and effectively driving its target rate to zero. Once the central bank takes the policy rate to zero, it removes any need to keep pressure on bank reserve positions to ensure that its target rate remains positive. Thus, without any need to keep control of its balance sheet, the central bank can begin to inject liquidity into the economy, or in the case of the United States, recapitalize the banks and repair the credit system.
Whereas it is technically possible for a central bank to engage in quantitative easing and still maintain a positive policy rate, the point here is that as the central banks engaged in quantitative easing policies, the foreign-exchange market became unmoored.
The strong rally in the value of the dollar that began in late 2008 accompanied the reduction in policy rates across the major trading states. However, once the U.S. Federal Reserve announced that it would engage in a robust policy of quantitative easing the greenback experienced a sharp reversal against the euro and the yen.
Yet, due to the pervasive problems in the European banking sector and the severe contraction in the euro zone economies, the duration and intensity of that correction was limited. Market participants doubted the resolve of European Central Bank authorities to maintain their policy stance of avoiding the quantitative easing regimes adopted by the Federal Reserve, Bank of England, Bank of Canada, Bank of Japan, and Swiss National Bank. At the first sign of weakness, the greenback saw gains against most major currencies as the financial crisis continued to roil global markets.

New Reserve Arrangements?

The near collapse of the global system of finance left the United States unable to provide the economic leadership necessary to coordinate global action to mitigate the synchronized slowdown in the international economy. Dissatisfaction with the role that the world’s reserve currency, the dollar, had played in the transmission of the crisis built among the countries in possession of capital account surpluses. At the April 2009 G-20 meeting one of the largest surplus countries, the People’s Republic of China (PRC), called for the creation of a new global reserve currency.
The PRC suggested that the special drawing rights (SDR), a reserve asset created by the International Monetary Fund in 1969 to supplement the reserves of member countries, be considered as a potential replacement.
The SDR, which serves as a unit of account based on a basket of currencies, would provide the IMF with the capacity to increase the global money supply in a crisis. Under the initial proposal, this would bestow upon the IMF a powerful tool to address problems in the emerging world and would provide a greater voice in the body to emerging economies.
Of course, it goes without saying that the advanced economies will be loath to surrender their power in the body or bequeath to an international body the ability to create money to pursue a political agenda that may have little to do with sound macroeconomic policy.
Beyond the considerable technical considerations and political hurdles, it is highly unlikely that the dollar will lose its position as the global reserve currency anytime soon. To create a market for a synthetic currency, such as a supersovereign SDR, would require a large and wealthy nation, not an international organization, to subsidize the cost of attracting buyers and sellers to participate in the creation of a new market over a period of time before it can become institutionalized.
The type of deep and liquid markets that would hold the attention of market participants are typically not the artificial creations of supranational authorities. Rather, they spontaneously develop based on the needs of buyers and sellers or savers and borrowers to fill unmet needs in the wider universe of markets.
Moreover, China holds nearly $2 trillion worth of U.S. Treasury securities, and central banks hold trillions more in dollars and dollar-denominated securities. The dollar is still the preeminent unit of account in much of the world. The question is, should the quantitative easing policy pursued by the U.S. central bank not succeed, will the dollar continue to be the primary reserve asset?