, but I hope from this that the reader gets a picture of charts being ableto reflect substantial amounts of potentially important information, information that in theabsence of major changes in fundamentals may be the primary reason for subsequent, futureprice action. Along with support, resistance and moving averages, there is another technicaltool that is useful in determining short-term moves in exchange rates – the relative strengthindex (RSI). The aim of this indicator is to discover overbought or oversold levels, againstwhich the index is measured. The time period for RSI is usually 14 days and overbought andoversold levels are usually taken as 70 and 30 for the index. Thus, we return to our Euro–dollarchart in Figure 4.7, including this time a reading of 14-day RSI.The two dotted lines indicate the 30 and 70 oversold and overbought levels for 14-day RSI.Hence, we can note from this that according to the chart the RSI reading is currently roughly inthe middle of its range. Combining this with the underlying chart, we note that at the same timeas the RSI reading is in the middle of its bands, Euro–dollar has broken to the upside of a trendchannel and the 55-day moving average has broken up through the 200-day moving average.We can potentially conclude from this that the benign RSI indicator may suggest there is moreupside to come. Note that the RSI reading usually exceeds its 70 or 30 overbought or oversoldlevels before the peak or trough in the spot exchange rate. RSI analysis can be particularlyuseful when comparing divergences between it and the spot price action. For instance, if a spotexchange rate is making new highs while the RSI reading has already peaked, it may suggestthat the spot exchange rate is itself about to peak and subsequently head lower.RSI is one type of technical indicator. More generally, technical indicators reflect a mathematical calculation that can be applied to either an exchange rate’s price or its volume. Theresult is of course a value, which is then used to try and predict future prices. By this definition, both RSI and moving averages are technical indicators. Another widely used technicalindicator is the moving average convergence divergence (MACD) indicator. The MACD isusually calculated by subtracting a 26-day moving average of an exchange rate from its 12-daymoving average. The result is an oscillator that reflects the convergence or divergence betweenthese moving averages. In Figure 4.8, we again compare the standard Euro–dollar price chartwith the 12/26-day MACD.Here, we get a somewhat different picture than shown by the RSI comparison. While thatappeared to suggest the Euro–dollar exchange rate may have been about to make further gainsgiven the benign RSI reading relative to the move higher in price, this MACD comparisonappears to be suggesting the opposite. For just at the time the Euro–dollar exchange rate ismaking gains, the MACD reading has clearly failed well ahead of its previous high and isheading lower. This suggests bearish divergence on MACD and a potentially bearish signal
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Figure 4.7 14-Day RSISource: Reuters. Copyright Reuters Limited, 1999, 2002.
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Figure 4.8 12/26-Day MACDSource: Reuters. Copyright Reuters Limited, 1999, 2002.
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as well for the Euro–dollar exchange rate. MACD oscillates above and below a zero level.When it is above zero, it means the 12-day moving average is higher than the 26-day movingaverage, which is potentially bullish as it suggests that “current” expectations (as reflected bythe 12-day moving average) are more bullish than those expectations made prior to the 12-daymoving average. Equally, when the MACD falls below zero, it suggests a bearish divergencebetween the moving averages. In our example, the MACD reading is still above zero, but it isheading lower towards that level.Moving averages and MACD are examples of lagging technical indicators as they reflectprevious price action and are particularly useful when an exchange rate trends over a longperiod of time. On the other hand, leading technical indicators give some indication of aprice being overbought or oversold, thus RSI is an example of a leading indicator. Divergenceoccurs when the exchange rate trend does not agree with the trend of the technical indicatorof that exchange rate. Hence, Figure 4.8 shows a clear example of bearish divergence usingMACD.
4.4 SCHOOLS OF (TECHNICAL) THOUGHTHaving gone through the basic building blocks of technical analysis and the technical indicatorsthat are used, we will now look at the major technical schools of thought that have dominatedthe way technical analysts and traders look at price patterns. The first one to focus on is theFibonacci school of thought, named after Leonardo Fibonacci, an Italian mathematician bornin 1170. Fibonacci discovered a series of numbers such that each number is the sum of the twoprevious numbers:1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233 and so on . . .To some, these numbers may seem more or less random. In fact, they are actually far fromrandom, containing important interrelationships, and they are found in a surprising number ofreal-life examples. Indeed, it is not too much of an exaggeration to suggest that these numbersrepresent the mathematical building blocks of life. For a start, note that any given number isroughly 1.618 times the previous one. Equally, any number is 0.618 times the following number.As it stands, this does not answer the question of how Fibonacci happened to found, albeitinadvertently, a type of technical analysis. For this, we have to look first at Fibonacci’s so-called“rabbit problem”, which relates to his attempt to demonstrate the application of Hindu–Arabicnumerals through the example of rabbits. The mathematical problem that Fibonacci posed isthat if two rabbits were put in an isolated place, how many pairs of rabbits could be producedfrom that pair in a year if every month each pair produces a new pair, which itself from thesecond month also becomes reproductive? At the start of the first month, there would only bethe first pair. By the start of the second month, there would be the original pair plus one newpair, resulting in two pairs of rabbits. However, during that second month, the original pairwill again produce another pair while the second pair is maturing. Thus, at the start of the thirdmonth, there should be three pairs, which brings us back to the Fibonacci number series. Interms of a mathematical formula, this can be expressed as:X n+1 = X n + X n−1where X n is the number of pairs of rabbits after n months.
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This became known as the Fibonacci sequence, as coined by the French mathematicianEdouard Lucas (1842–1891). As the Fibonacci sequence progresses, a clear relationship between the numbers becomes apparent, as reflected by the 0.618 and 1.618 ratios mentionedabove. The very fact that there can be a consistent ratio between numbers is itself “statisticallysignificant”, confirming that there is more in this than just a random series of numbers. Notealso that if you take any number and divide it by the number two higher in the sequence theratio comes to 0.382. Not coincidentally, 38.2% and 61.8% are major Fibonacci retracementlevels within the Fibonacci school of technical analysis.While we look to Fibonacci and Lucas as the founders of modern-day Fibonacci analysis, itappears that long before them the importance of this sequence of numbers and ratios was wellknown and appreciated. Indeed, these ratios appear to have been used in the construction ofboth the Great Pyramid of Giza in Egypt and the Parthenon in Greece. The 0.618 or 1.618 ratio,also known as the Golden ratio, is commonly viewed in mathematics as one of the buildingblocks of natural growth patterns – in geometry as in life. Even the human body can be shownto contain elements of the Golden ratio, measuring the distance from the feet to the navel andin turn from the navel to the top of the head as a ratio. The basic building block of humanbeings, the DNA double helix, also contains the Golden ratio.The link between Fibonacci and financial markets comes through another school of thoughtfor technical analysis, Elliott Wave Theory, named after Ralph Nelson Elliott (1871–1948).Elliott first made the connection between his Wave Theory and the Fibonacci sequence ofnumbers in his book Nature’s Law – The Secret of the Universe (1946). Elliott Wave Theorysuggests financial markets move in five waves of progression followed by three waves ofregression. As such a 5–3 wave move completes a wave cycle. The five “up” waves arelabelled 1–5, while the three “down” waves are labelled a–c. Of necessity, waves 1, 3 and 5are seen as impulsive waves while waves 2 and 4 are seen as corrective.Remembering the Fibonacci sequence, it should be immediately obvious that 1, 3 and 5 areFibonacci numbers. Furthermore, if we break each wave down into sub-waves, we notice twothings, firstly that each sub-wave conforms to the 5–3 wave pattern and secondly that whenwe add up these sub-waves we come to 21 impulsive and 13 corrective waves, making 34 intotal. Once again, 13, 21 and 34 are all Fibonacci sequence numbers.Fibonacci sequence numbers are also used in other technical indicators, such as in movingaverages – e.g. 5, 13 and 21 moving averages, 21, 34 and 55 or 31, 55 and 144. Within thefinancial markets, the most widely used application of the Golden ratio is through the Fibonacciretracement, which relates to the fact that corrective waves have retraced the previous wave by38.2%, 50% or 61.8%. Fibonacci fan lines provide key support or resistance corresponding tothe Fibonacci retracement levels. Once such a Fibonacci fan line support or resistance has beenbroken, this tends to suggest the extension of a correction and thus a potential wave reversal.In sum, Fibonacci levels can provide crucial tops and bottoms in the market and are widelywatched by both short- and medium-term currency market participants.A final school of thought is Gann Theory, created by W.D. Gann (1878–1955), whichseeks to predict future prices using specific geometric angles. Gann angles or Gann lines canbe created by graphing price against time. The basic Gann angle or line is created by assumingan increase in one unit for both price and time, resulting in a line which is at a 45◦ angle toboth axes. Because of the price and time increases involved, this is called a 1 × 1 angle. Gannlines are drawn off major price tops and bottoms. If the price is above the 1 × 1 line, thissignals a bullish trend and conversely if it breaks below the line this signals a bearish reversal.
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Including the 1 × 1 angle, Gann identified nine significant angles or lines relating to price andtime:
r 1 × 8 – 82.5 degreesr 1 × 4 – 75 degreesr 1 × 3 – 71.25 degreesr 1 × 2 – 63.75 degreesr 1 × 1 – 45 degreesr 2 × 1 – 26.25 degreesr 3 × 1 – 18.75 degreesr 4 × 1 – 15 degreesr 8 × 1 – 7.5 degreesEach of the angles or lines can provide a support or resistance depending on the trend.Generally speaking, the 1 × 1 angle as reflected by a trend-line is not sustainable given thesteepness of the angle involved. Prices cannot continue appreciating at a 45◦ angle forever.The 3 × 1 angle is generally viewed as more sustainable in terms of price trends over the longterm.
4.5 TECHNICAL ANALYSIS AND CURRENCYMARKET PRACTITIONERSThe various techniques of technical analysis, which we have only briefly touched on here, havebeen widely practiced by traders for a very long time – centuries rather than years. The firstfutures market was created in Japan in the early 1800s and the Japanese candlestick chartingtheory is seen as having emerged on the back of this. The very fact that we can chart USTreasuries back to the American Civil War confirms that the art of charting is also hardly anew phenomenon in the US either. While currency, equity and fixed income traders have longfollowed technical signals, corporations and asset managers have on the whole been somewhatmore reticent to do so, either because of scepticism as to the merits of technical analysis ora lack of knowledge of how it works – or both. The best advance of any type of analyticaldiscipline is that it actually works in practice; that it is capable of predicting exchange rates inthis case and therefore using it one can generate excess returns. As Osler shows in her piece“Support for resistance: technical analysis and intraday exchange rates”,3 empirical evidencedemonstrates that technical analysis can help in exchange rate prediction over and above theresults available by simply using a random walk theory. Simply put, there is something to this.Looking at a slightly longer time frame, can a corporate Treasurer or an investor use technicalanalysis as part of their currency risk decision? The answer in this case is also, yes they can.While the primary focus of technical analysis is short term, it is fully capable of predictingmulti-month of even multi-year moves. As an example, at the end of 1999, when the dollar–randexchange rate was trading at around 6, the CitiFX Technicals team put out a buy signal, basedon a combination of Elliott Wave Theory and the “golden cross” between the 55- and 200-day3Carol L. Osler, “Support for resistance: technical analysis and intraday exchange rates”, Economic Policy Review, 6(2) (July2000). For other studies of technical analysis, look at Helen Allen and Mark Taylor, “The use of technical analysis in the foreignexchange market”, Journal of International Money and Finance, June 1992; Kevin Chang and Carol Osler, “Methodical madness:technical analysis and the irrationality of exchange rate forecasts”, Economic Journal, October 1998; John Murphy, Technical Analysisof the Futures Market: A Comprehensive Guide to Trading Methods, Prentice Hall, 1986.
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moving averages, with a multi-year target of 9.4 The exchange rate hit 9.00 on September27, 2001. Again, the sceptical may see this as coincidence. However the fact is that skilfulapplication of technical analysis principles correctly forecasts a move in the exchange ratethat no interpretation of the “fundamentals” would have provided. At the very least, technicalanalysis should be a consideration for all types of currency market practitioner. Short-termtraders are likely to use it as their primary analytical tool ahead of fundamental analysisbecause it is better suited to predicting short-term exchange rate moves than the traditionalfundamental exchange rate models. Corporations and asset managers can use it as a crosscheckof their fundamental views and also in terms of timing their hedging activity. The fact that traderswatch technical levels and that traders make up the majority of currency market participantsautomatically makes those levels important.What we have attempted in this chapter is to look at the basic principles and schools ofthought within technical analysis, along with how and why it works. Having looked at pricingpatterns, it is also important to look at the structural dynamics that determine that price. Thatis to say, one can look at a chart of an exchange rate, but it is also important to know howthat price has been created and under what circumstances. Indeed, the type of exchange rateregime can render virtually worthless for periods of time most types of analysis, distortingboth the fundamental and the technical signals that might otherwise be read. Thus, in the nextchapter we take a look at the types of exchange rate regime and how each type might impactthe exchange rate itself.4
Martin Armitage-Smith/Tom Fitzpatrick, CitiFX Technicals Bulletin.
Part TwoRegimes and Crises
5Exchange Rate Regimes: Fixed orFloating?To most modern-day readers, at least those within the developed markets, the exchange ratenorm is and has always been freely floating. All sectors of society have become used tovolatile exchange rates and have learned to plan accordingly. Individuals plan vacations whenthe currencies of their planned vacation destination are perceived as cheap. Businesses seekto hedge their transactional or translational risk according to a combination of their businessneeds and market conditions. Politicians have a mixed record with floating exchange rates,frequently viewing exchange rate strength as a sign of national economic virility – and exchangerate weakness consequently as a test of their own administration. Yet, it is not that long agothat such a test would have been inconceivable. Freely floating exchange rates are themselvesa relatively recent phenomenon. Indeed, the period since 1973 and the break-up of the BrettonWoods exchange rate system has been the first sustained time in history in which the world’smajor currencies have not been pegged to some form or other of commodity. Such a world offreely floating exchange rates, massive private capital flows financing current account deficitsand markets dictating government monetary and fiscal policies was completely inconceivablein 1944 when Bretton Woods was created. To recap, under this, member countries pledged tomaintain their currencies within narrow bands against the US dollar, while the dollar itself waspegged to gold (at USD35 per ounce). Some degree of flexibility was allowed, but there wasnever any suggestion – or conception – that governments were not in charge. For 27 years, theBretton Woods system held in place, helping to provide a foundation for economic growth inthe 1950s and 1960s.Then, as the value of the US dollar peg to gold came under ever increasing pressure, theUS eventually scrapped its gold peg, trying in the process to create a slightly more flexibleexchange rate system under the Smithsonian Agreement. In 1973, the effort to defend thistoo was exhausted and collapsed under the weight of its own contradictions. Thus, since1973, we have had for the first time an international monetary system which has for themost part been characterized by freely floating exchange rates among the major industrialcountries, free of official intervention or commodity-related pegs, with “the market” takingan increasingly important role, both relative to before 1973 and also to official governmentpolicy. Granted, since then, there have been several attempts, such as the Exchange RateMechanism (ERM), to shackle exchange rates within narrow bands. For the most part, suchattempts to reassert government control over the market have given way to some degree ofaccommodation between the two sides, with freely floating exchange rates allowed but officialintervention seen as appropriate at times of extreme volatility or where prices have “overshot”economic fundamentals. This accommodation has resulted in specific victories of a sort for bothsides. The ERM itself, having barely survived the 1992 crisis, was forced under extraordinarypressure in 1993 to widen its bands to ±15% from ±2.25%. However, since then, membercountries have relinquished their national currencies in favour of the Euro, thus eliminating
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the question of fixed or floating at the national level. The Euro itself is still however a freelyfloating currency, as its volatile movements have born testimony.Still, for the most part, the question of having a fixed or floating exchange rate regime hasincreasingly become a redundancy for the world’s industrial countries, particularly as barriersto trade and capital have been broken down. The US dollar, Euro, yen, sterling and othersall float against each other, for the most part without official interference. While there arestill occasional bouts of intervention by the central bank, these are nowadays a relative rarity.What has become far more common is that central banks will attempt to guide the marketthrough “verbal intervention”. The extent of the accommodation arrived at by the market andthe official community is such that this for the most part works well enough, though to besure there are times when it is not enough and substantial foreign exchange intervention inthe market has to be undertaken. For currency market practitioners in the industrial countrieshowever, such as corporations or institutional investors, the question of the type of exchangerate regime is largely (though perhaps not completely) no longer relevant. National currenciesmay bind together to become regional currencies, but the bottom line is that they are still freelyfloating and not artificially pegged.
5.1 AN EMERGING WORLDThis is not the case in the “emerging markets” or “developing countries”. While there hasundoubtedly been a gradual trend towards freely floating exchange rates within the emergingmarkets, whether willingly or otherwise, many still have some form of peg arrangement,depending to some degree upon their state of development. Thus the question of the type ofexchange rate system – fixed or floating – remains particularly pertinent for currency marketpractitioners who are involved in the emerging markets. In order to suggest how currencymarket practitioners might deal with exchange rate system issues, it might be useful to explainfirst why these exchange rate systems came about in the wake of the developments of 1973and how each type works.When – or if – one thinks about the 1970s, it is usually from a political perspective, as a timeof war and revolt against war, as a time of political and social revolution. Nowadays, many ofthe protestors of that time are in business. Politically, much has changed. The economic worldhas also changed massively, to some extent in line with some of these political shifts. Thedecline of the Soviet Union coincided with the decline of the socialist attempt at economics.People who were finally able to turn on their television in the Warsaw Pact countries and tunethem to Western stations found they had been lied to for a generation. The triumph of capitalismwas confirmed. From that time, when West and East no longer glared down the barrel of a gunat each other (or more aptly the nose cone of an ICBM), such terms as “market economy” and“globalization” have developed. Just as we now take for granted floating exchange rates, so wealso take for granted free trade and capital mobility, yet many of these were the direct resultof the end of the Cold War.With the decline of the Soviet Union and the end of the Cold War, emerging market countrieshave been able to move away from being mere chess pieces in a bi-polar world. Crucially, thebreaking down of barriers to trade and capital, which began in the late 1980s and acceleratedin the 1990s, has allowed them to participate to an increasing degree in the global economy. Asthe role of the emerging markets has increased within the global economy, and perhaps morespecifically within global financial markets, so the pressure has grown on them over time to
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adopt more flexible exchange rate systems to be able to absorb the periodic shocks that freetrade and free capital markets entail.
5.2 A BRIEF HISTORY OF EMERGING MARKETEXCHANGE RATESThe history of emerging market currencies and exchange rate systems can most usefully bedivided into four main periods – 1973–1981, 1982–1990, 1991–1994 and 1995–2001.1973–1981For the most part, this period saw relative exchange rate stability, not least because most emerging market currencies were not freely convertible either on the current or capital accounts. Therewas a steady if modest capital outflow from the industrial countries to the emerging markets,which were mostly at that time dependent on commodities rather than the manufacturing basesthey would become.1982–1990If the previous period was characterized by stability that of 1982–1990 was one of anarchyfollowed by a gradual attempt at restructuring. Massive tightening of monetary policy in the USand a consequent dramatic rise in the US dollar, plunging commodity prices and a reversal incapital flows out of the emerging markets combined to trigger first emerging market currencydevaluations and then defaults, most notably in Mexico and also elsewhere in Latin America.Given ensuing capital flight, many emerging market countries sought to impose capital controls,driving interest rates artificially low in response. The gradual debt restructuring process during1985–1990 helped restore some stability to emerging markets, helped in part by lower interestrates in the US and a sharp fall in the value of the US dollar. The currency devaluations andthen low nominal interest rates – and negative real rates – as capital controls were imposed,resulting in very poor returns for passive currency investors.1991–1994This was the heyday for the emerging markets. As the Berlin Wall was torn down, so the Eastwas opened up to investment. Latin America had a slightly better time of it as economiesgradually recovered in the wake of the Brady bond-restructuring programme. Capital controlswere lifted, largely as demanded by the IMF, and domestic interest rates, which had been keptartificially low, were set free to the whim of market forces. “Privatization” of state assets wasgreatly accelerated, supporting budget balances and helping to attract capital inflows. Risinginterest and exchange rates greatly boosted total returns for currency investors during thisperiod. In light of this, the Mexican peso devaluation of December 1994 came as rather a rudeawakening.1995–This last period has been characterized above all by volatility, on the one hand by hugecapital inflows and on the other hand by frequent currency devaluations. One by one, pegged
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exchange rate regimes tried to defend themselves, tried to delay the inevitable. However, capitalmobility, coupled with pegged exchange rate regimes and in some cases a degree of monetaryindependence were a poor policy mix, forgetting the principles of Mundell–Fleming, and oneby one they were forced off their pegs, to “float” (devalue) their currencies. Among thoseemerging market currencies forced to devalue during this time were:
r 1994/95 – Mexicor 1996 – Czech Republicr 1997/98 – Asian region (Thailand, Indonesia, Korea, Philippines)r 1998 – Russiar 1999 – Brazilr 1999 – Ecuadorr 2000 – Colombiar 2001 – Turkey
The year 2002 has brought with it so far the devaluation of the Argentine peso, the first“currency board” in history to be defeated, and also that of the Venezuelan Bolivar. There havealso been cases where emerging market countries have either had some success in fighting backor alternatively have de-pegged voluntarily during periods of exchange rate stability, rightlyanticipating that a freely-floating exchange rate would provide a far more effective buffer forthe economy during subsequent periods of market turbulence than the alternative, which wouldrequire defending an overvalued exchange rate. In the first camp, we have had countries such asMalaysia and also Hong Kong, which have tried various strategies to fight the market. Malaysia,for its part, in September 1998 banned offshore trading of the Malaysian ringgit and pegged itto the US dollar at 3.8 – where it has stayed ever since. Hong Kong, long the self-proclaimedbastion of the free market, intervened in the stock market, ostensibly to rid it of “manipulative,speculative elements”. In the second camp, countries like Chile, Poland and Hungary havede-pegged their exchange rates voluntarily, under calm and stable market conditions. As aresult, when market conditions became more volatile, the freely floating exchange rate wasable to buffer or insulate the real economy from damaging imbalances or instability.As the emerging markets became integrated into the global economy and particularly withinthe global financial system rather than just commercial trade, so the pressure became irresistiblefor them to move from a fixed or pegged exchange rate system to more flexible exchange ratearrangements, such as the free float – the reed that bends in the wind, rather than the pane of glassthat shatters. Two major trends in terms of the liberalization of capital markets have playeda major part in the development and history of exchange rate systems within the emergingmarkets – the rise of capital flows and the opening of the emerging markets to international trade.5.2.1 The Rise of Capital FlowsA key reason for the move by emerging markets from pegged exchange rates to floatingexchange rates has been the rise in the importance of global capital flows and the extent towhich emerging markets have participated in and been integrated within those capital flows.As stated, the rise in the importance of capital flows since the early 1980s reflects the waveof capital account liberalization and capital market integration that has taken place since thattime. As a proportion of GDP, capital inflows to the emerging markets rose six-fold in the1990s relative to the 1970s and 1980s, only to fall back in 1998 in the wake of the