Insight Line—April 14, 2008

As I have noted in previous Insight Line commentaries, currency exchange rates are a complex and interactive mechanism influenced by many different forces—most of which are almost devoid of explanation.

To be sure, much of the academic research on the subject concludes that the next piece of market moving information, as well as the direction of the next short-term move, is random. But, could the short-term randomness be obscuring the long-run pattern?

Interestingly enough, when discussing exchange rate movements of the dollar, the answer appears to be yes. Writing for Ned Davis Research, senior global analyst Ed Clissold suggests the existence of a seven-plus year cyclical pattern to the world exchange value of the U.S. dollar, as detailed in the accompanying chart. Although his findings rest more on time cycles (and other inputs) than magnitude of change, I find his conclusion intriguing as it refocuses the discussion from short-term blips to long-term trends. Granted, accepting the past as prologue is ill advised. However, to ignore it, especially at what appear to be points of inflection, is equally foolhardy, in my view. Said differently, if Clissold’s findings are correct, the world exchange rate value of the dollar bottomed late last month. 

U.S. Dollar Index Major Turning Points 1

Start Date	End Date	Years	% Change
8/13/71	10/27/78	7.21	-29.2
10/27/78	3/8/85	6.36	95.6
3/8/85	9/4/92	7.49	-51.2
9/4/92	7/6/01	8.84	52.1
7/6/01	3/28/08	6.73	-40.3
Median*		7.35
Uptrends		7.60	73.9
Downtrends*		7.35	-40.2
* Current Case Not Included
Ned Davis Research, Inc.   T_COD200804081

However, before we go too far out on a limb, I suggest it important to acknowledge that while forecasting foreign exchange rates seems relatively straightforward—given that the differential between currencies should be little more than a supply-demand equation—nothing could be farther from the truth. Just turn to the preponderance of well conceived, well supported research on the ability (or lack thereof) to predict exchange rates. Characteristically presented under topics such as purchasing power parity, balance of payments, and rational present value models, the goal has been to disprove the 1983 landmark analysis of Richard Meese and Kenneth Rogoff, which concluded that in the short-term predicting exchange rate differentials defy description.² However, to date, no analysis has come close to that goal. Even the Federal Reserve Board of Governors research group weighed in on the subject, concluding, “The inability to anticipate changes in supply and demand for a currency is at the root of the statistically robust finding that forecasting exchange rates has a success rate no better than that of forecasting the outcome of a coin toss."³

To be sure, most equity investors have little knowledge of foreign currency trading patterns, history or fundamentals. As such, I suggest they may too readily accept “expert” predictions on the meaning of short-term price movements with little regard to longer-term trends. Thus, as I see it, if Mr. Clissold’s analysis proves correct, the recent bottom of the Federal Reserve’s U.S. Trade-Weighted Major Currency Dollar Index, which measures the trade-weighted foreign exchange value of the dollar against major currencies, on March 18, 2008, was a headline that did not make it to the front page.

¹ Clissold, Ed, Chart of the Day, “The Dollar’s Seven-Year Itch,” Ned Davis Research, Inc., April 8, 2008, ©2008 Ned Davis Research, Inc.

² Meese, Richard and Kenneth Rogoff, “Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?” Journal of International Economics 1983, #14, pages 3–24. Note: reference is a restricted access download.

³ Greenspan, Alan, “Panel Discussion: Euro in Wider Circles,” remarks at the European Banking Congress 2004, Frankfurt, Germany, November 19, 2004, page 3. Available at http://www.federalreserve.gov/newsevents/speech/2004speech.htm

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.