smaller volumes than the extent of their declines might havesuggested. The Korean won collapsed along with the Thai baht, Indonesian rupiah, Philippinepeso and at least initially the Malaysian ringgit. Despite this, there was no immediate reductionof Asian trade and current account deficits. Analysts of the Asian crisis will no doubt suggestthat other factors were also at work, notably the high importer content within Asian exports.While this was undoubtedly the case, it does not detract from the fact that there was a clearand marked delay between the exchange rate move and the adjustment to the trade balance.For whatever reasons, Korean corporations delayed their price increases.We can also see this at work from the angle of the exchange rate rather than the trade balance.As an exchange rate appreciates, it causes exports to become more expensive in the currencyto which these exports are going and imports from that country to become cheaper. The initialreaction in the trade balance is not negative however. As the exchange rate appreciates, it causesexport prices to rise and import prices to fall. This in turn causes the value of exports to risevs. imports, thus the initial reaction in the J-curve is that the trade balance actually improves.While this is happening, however, the impact of higher export prices reduces demand for thoseexports, causing falling export volumes. In turn, falling export volumes eventually lead to afall in the value of exports and thus to a deterioration in the trade balance. The delay betweenthe fall in export volumes and export values and the subsequent impact on the exchange rateis reflected by the concept of the J-curve. That delay factor varies between exchange ratesdepending on specific export price sensitivity to changes in the exchange rate.
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ExampleThe J-curve delay in the dollar–yen exchange rate has traditionally been two to three years. Inother words, it has usually taken two to three years between a major move in this exchangerate and a subsequent reaction in Japan’s trade and current account balances. The delay canvary even within the same exchange rate depending on the predictability of the exchange ratemove.For instance, during 1993–1995, the dollar–yen exchange rate fell consistently amid marketconcerns that the US administration was trying to devalue the US dollar deliberately as a tradeploy to bring Japan to the negotiating table on opening up their economy to US exports. Yenexchange rate appreciation caused a real economic shock to Japan’s economy. Japanese exportvalues rose initially as the value of the yen rose. While the higher value of the Japanese yenpushed Japanese export prices higher, theoretically Japanese manufacturers would be reluctantto pass that price rise on for fear that US consumers would not tolerate it and that as a resultthey would lose significant sales and market share. Indeed, they tried to keep price increaseslimited as much as possible, sacrificing margin for sales and market share. Eventually, however,they had to pass on some of the price rise to offset declining export volumes. The result wasof course that trend appreciation of the Japanese yen led to a significant decline in Japan’scurrent account surplus, but only from 1995 to 1996, some two to three years after the yenappreciation had begun. Similarly, the yen trended lower from the end of 1995 to mid-1998 inresponse to the deterioration in the current account balance, eventually to the point whereby itcaused renewed recovery in that current account balance, providing at least part of the reasonfor the yen’s dramatic recovery against the US dollar in August and September of 1998.
2.2.3 The Real Effective Exchange RateAs noted in Chapter 1, the REER is the trade-weighted exchange rate (NEER) adjusted forinflation. It is viewed as a good indicator of medium- to long-term currency valuation. If we lookat the Russian and Turkish crises, we see beforehand that the Russian rouble and Turkish lirawere around 50–60% overvalued on a REER basis. This provides extremely useful informationin that it actually suggests that the rouble and the lira will have to experience significant realexchange rate depreciations to restore equilibrium. That’s the good news. The bad news is thatit does not tell you when that significant real – and therefore nominal – depreciation will takeplace. In both cases, the rouble and the lira were overvalued for two to three years before theinevitable happened.However, there are important clues as to when that REER appreciation may be about toend. Such REER appreciation usually causes significant trade and current account balancedeterioration. The fact that this does not have an immediate reaction in the exchange rateconfirms not only the existence of the J-curve but also the presence of significant capitalinflows. Such inflows can offset a widening trade deficit for a period of time, but eventuallyare not able to. When they reverse, or rather when they just stop, the exchange rate comesunder ever increasing pressure until such time as it collapses to restore equilibrium. Thisprocess can also work equally well with real depreciations. From the end of 1995 to mid-1998the Japanese yen experienced an increasing REER depreciation. Capital outflows offset anincreasingly improving current account balance until such time as they could no longer doso, whereupon the Japanese yen rallied significantly, resulting in one of the most dramaticcollapses in the dollar–yen exchange rate – or any exchange rate – in history. REER valuation
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and the external balance are both cause and effect. It takes a REER depreciation of a currencyto narrow significantly a large external imbalance. That said, an excessive REER appreciationcan cause that imbalance in the first place.
2.3 SUMMARYIn sum, the aim of establishing an analytical discipline called currency economics is to adoptan integrated approach to exchange rate analysis, pooling those existing strengths of classicaleconomics together with newer ideas based on capital flows into a combined framework whichseeks to analyse exchange rates right across the spectrum of short-, medium- and long-termexchange rate views. The field of currency economics also seeks to differentiate between shortterm cyclical factors such as monetary and fiscal policy and long-term structural factors suchas persistent trends in the current account balance, REER valuation and PPP, in affecting theexchange rate. Currency economics seeks to make the economic analysis of exchange ratesmore relevant to short-term exchange rate moves, particularly in its attempt to focus on thecapital account and capital flows. In doing so, it provides better exchange rate forecastingresults than is the case with the traditional exchange rate models. However, the delay to theadjustment mechanism that bedevils the attempt by classical economic analysis to forecastexchange rates is also present within currency economics. For a truly real-time, market-basedfocus on forecasting exchange rates, we have to turn to analytical disciplines that are specificallytargeted at short-term exchange rate moves, such as flow and technical analysis.
3Flow: Tracking the Animal SpiritsWithin financial circles, it has become commonplace to talk about the importance of “flow”in forecasting exchange rates. International organizations and academic bodies now publishan increasing number of research papers on capital flow and how it affects economic policies.For instance, the IMF publishes its quarterly review of Emerging Market Financing, lookingat trends over the quarter in equity, fixed income and foreign exchange flows, syndicated andofficial loans and direct investment. Looking at a slightly different time frame, several bankresearch departments now use intraday flow in the fixed income and foreign exchange marketsto predict short-term exchange rate moves.All of this marks a major departure from the previous orthodoxy. As we looked at in the firsttwo chapters, the traditional exchange rate models are based on several important assumptions,including the view that markets are essentially rational, that information is perfect (i.e. availableto everyone, all of the time) and that divergences from fundamental equilibrium levels willeventually be eliminated. Because of this, it was also assumed until quite recently that therewas little point in studying financial market “flow”. If a price is the result of all availableinformation at one time, and if all information is equally available to all concerned withinthe financial markets, flow information cannot add any value or have any price effect as thatinformation is already known. Moreover, economic fundamentals will dictate over time thatcapital flows so as to eliminate fundamental imbalances and price over- or undervaluation.In sum, the economists deemed themselves as being in full control of what they appeared toperceive as the rather unseemly elements of the financial markets, i.e. the actual participants.Economics was the “cause” and capital flow the “effect”.Some within the economic community diverged somewhat from this polar view, notablyone John Maynard Keynes, who coined the term “the animal spirits”, referring to the stockmarket and the way in which economic theory and financial market prices interacted. Morerecently, perhaps within the last decade, there has been a fundamental realization within theeconomic community, albeit perhaps a grudging one, that capital flow can be both cause andeffect in its relationship with economics, that it is just as likely to change as to be changed byeconomic fundamentals.In short, there has been a realization that the efficient market hypothesis, which haslong dominated economic theory, is itself flawed. While we looked at this issue briefly inChapters 1 and 2, it is important here to examine its specific flaws given the context of howcapital flows can affect price. To recap, an efficient market is one where all relevant marketinformation is known to market participants, who act rationally in accordance with economicfundamentals to quickly eliminate any divergences from fundamental equilibrium. This idea isultimately flawed for the following reasons:
r Information is perfect – As we saw in Chapters 1 and 2, this is a nonsense. There areconsistent inefficiencies in information availability and usage.
r Markets are efficient – If financial markets were fully efficient, there would be no such thingas a sustained divergence from fundamental equilibrium.
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r Market participants are inherently rational – Rationality is itself inherently a subjective term,as is fundamental equilibrium.
r Market imbalances are eliminated and prices return to fundamental equilibrium – The realityis rather different. A host of academic papers have looked at the issue of exchange ratevaluation and generally found that the traditional exchange rate models have had poor results,leading some to conclude exchange rates are not determined by economic fundamentals overthe short term.1Efficient market theory essentially suggests that it is impossible to make excess returns inexchange rate markets because efficient markets should eliminate profitable opportunitiesbefore investors are able to capture them. Empirical evidence suggests this is simply not thecase. Investors have been able to make consistently good excess returns in the currency marketsover time. Some would see this as being due to market inefficiency, while others see it as beingdue more practically to good trading technique, as in any financial market. Information isimperfect, market participants are not necessarily rational in the sense the theory demands andultimately markets are frequently inefficient. For these very reasons, analysts and investors canindeed recognize and capture profitable opportunities. The fact that some achieve better resultsthan others is explained simply by the fact that some are better analysts, traders or investorsthan others.The subject of this chapter deals specifically with the concept of “flow”, and thereforeit is the inefficiency of market information that we are interested in here. If we accept thatmarket information is imperfect, that not all information is available to all at the same timeand therefore that the price does not reflect all information, then we must try and determinetwo things:
r What specific types of information are “in the price” at any one time?r What types of information are important for price movement on a sustained basis?It is probably best to look at these two issues as one. In the real world of a foreign exchangedealing room in London or New York, prices are indeed affected by the types of information thateconomic theory might expect, such as macroeconomic data, specific trends in microeconomicperformance and so forth. However, to provide liquidity for customers and also to make atrading profit for themselves, currency dealers have to trade, irrespective of whether there havebeen changes in economic fundamentals. Hence, currency interbank dealers, who make upthe majority of currency market participants – interbank dealing makes up around 65% ofall spot transactions – seek out other types of information, perhaps more suited to their ultrashort-term time horizon. Technical analysis is one of these, and we shall look at this fascinatingdiscipline in Chapter 4. In addition, currency dealers look at a bank’s “order book”, at the bookcontaining all the bank’s customer orders in an attempt to gauge prevailing market “sentiment”towards specific exchange rates. The sum of those orders may give a very useful indication ofhow specific client types feel about specific currencies. Note that this is not in any way tryingto gauge specific client orders in order to trade ahead of those (“front-running”). Rather,it is achieving an understanding of how the client base as a whole views certain exchangerates.1Readers who are interested in pursuing this further should look at Kenneth Froot and Kenneth Rogoff, Perspectives on PPP andLong-Run Real Exchange Rates, NBER Working Paper 4952, 1994; Rudiger Dornbusch, Real Exchange Rates and Macroeconomics,NBER Working Paper 2775, 1988; Jeffrey Frankel and Andrew Rose, A Survey of Empirical Research on Nominal Exchange Rates,NBER Working Paper 4865, 1994.
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People talk about “the market” in a rather abstract sense in terms of market sentiment towardsa specific asset or currency. However real this term may be to the user, it is still excessivelyvague. Far more useful for our purposes is to look at trends in actual transactions or the sumof orders that have been put in the market for the dealer to execute when the price hits theorder level. The sum of orders or actual transactions of a major commercial or investment bankcan be a far more accurate and representative gauge of “the market”. There have been severalimportant papers about this very subject, notably one by Evans and Lyons (1999),2 whichlooked at the principle of “order flow”, as being a key determinant of short-term exchangerate fluctuations. Another by the Federal Reserve Bank of New York (Osler, 2000)3 looked atthe same issue. Both focus on the idea that there is information surrounding actual currencytransactions and orders to be transacted which can not only explain exchange rate movements,but also be helpful in forecasting future exchange rate moves – something that would beimpossible if the efficient market hypothesis were correct.The Evans and Lyons paper found that order flow accounted for about two-thirds of dailyvariation in the US dollar–Deutschmark exchange rate over the time studied. The main cause ofthe exchange rate variation was shifts in private capital flows. Interestingly, these shifts appearedto take place in the absence of major changes in economic information. Such private capital flowshifts can happen as a result of changes in investor risk tolerance, liquidity, portfolio balancingneeds, hedging needs and so forth. In other words, they can happen for microeconomic aswell as macroeconomic reasons, reasons that are due to the specifics of the investor’s ownrisk tolerance profile and attitude to the market. The trade exchange rate models are not reallydesigned to take account of such factors, and thus it would appear others are needed that areable to do so.If exchange rates can be affected by the specifics of an individual investor’s risk toleranceprofile – something we know intuitively, but have now seen proven empirically – then suchmodels need to track not fundamental equilibrium but the actions of the investors concerned.At a broader level, the idea that we need to track the sum of investor behaviour and intentionshas sprung the school of thought known as behavioural finance. This field seeks to examinehow and why investor “herding” takes place, how to anticipate it and finally how to anticipatereversion to fundamental mean. More narrowly, models have been developed to track thesum of client orders and transactions. These actions are compared to exchange rate priceson a real time, live basis. If there is a good correlation between the sum of client orders andtransactions and those exchange rate prices, then one effectively has a model which can not onlytrack the relationship between the two, but also forecast future exchange rates based on thoseactions.This intellectual shift in favour of behavioural finance has happened in part because of theneed to find models that are more appropriate to market needs and also to try and explain howmarket “sentiment” or “psychology” can affect prices. In addition, major trends within financeitself have also provided support for the view that the “behaviour” of financial markets needsto be studied, that capital flows are not just “effect” but can also be the “cause” of marketmovement. These trends can broadly be divided into two main ones. Firstly, as barriers tocapital have been pulled down over the last 30 years, the size of those flows and therefore their2For more on this see Martin D.D. Evans and Richard K. Lyons, Order flow and exchange rate dynamics, Journal of PoliticalEconomy, August 1999; or Martin D.D. Evans and Richard K. Lyons, Why order flow explains exchange rates, Journal of PoliticalEconomy, November 2001.3Carol L. Osler, Currency Orders and Exchange Rate Dynamics: Explaining the Success of Technical Analysis, Federal ReserveBank of New York Staff Report No. 125, April 2001.
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effect on the global economy has grown exponentially. Today, we more or less take for grantedthe fact that we can buy a mutual fund or unit trust that focuses on Thai or New Zealand stocks,safe in the knowledge that money transfer, clearing, settlement and broker account processesare all seamless. Where we travel, we presume now also that we can invest. All this, we take forgranted. Yet, to our grandparents, this would be a wholly foreign idea. It was not that long agothat capital investment focused domestically rather than abroad. Over the last 30 years, just astrade has expanded so has the means by which to finance that trade, which is of course wherecapital flows come in. Indeed, since the war, it is only in the last 30 years that the proportion oftrade within the overall US economy has grown significantly, from around 10% to 15%. As UScompanies have expanded abroad, so their need for financing abroad has also grown. So-called“natural” hedging involves the matching of assets and liabilities. Thus, a US company mayinvest in a factory in Poland and wish to finance that asset by raising Polish zloty debt, as anexample. Previously, it was not possible to do this kind of funding operation given regulationsagainst foreigners within emerging markets. In the developed world, also, regulations againstcapital raising and movement also inhibited commercial trade for much of this century. Asbarriers to trade have fallen away, so have the barriers to capital as a means to finance thattrade. Further, as these barriers have fallen, capital flow growth has been a multiple of tradegrowth. This can only be sufficiently explained by an anecdote. Every day, the equivalent ofa year’s worth of global trade passes through the global currency market! Every week, thecurrency market trades the equivalent of the Gross Domestic Product of the United States! Thedevelopment of capital flow began as a natural ally and accompaniment to commercial trade.In the past two or three decades, it has far outgrown it.A second trend has been the realization of the growing importance of capital flow withrespect to the various emerging market crises that have occurred in the 1990s. It had also beenassumed that capital flows were a wholly beneficial thing that they helped a country to grow,indeed that they were the fuel for economic growth, not just at a national but also at a globallevel. For this reason, when capital outflows were seen as responsible for the financial andeconomic collapse of Mexico in 1994–1995, much of Asia in 1997–1998, Russia in 1998,Brazil in 1999 and Turkey in 2001 there was an understandable backlash. Having been seen asthe saviour of emerging markets, helping them to emerge from the poverty of the early post-waryears, capital flows were suddenly portrayed as a heartless villain, preying on the weak. Thereality of course is that they were never an entirely beneficial force in the first place, just asthey are not now the villain. To ascribe to capital flows human characteristics is to miss thepoint. Capital flows are neither trying to benefit nor are they trying to hurt a country. The onlyreason for them to be there is to make a return, to make money. If they can make a sufficientreturn, they will be attracted to a country and stay there. If they cannot make a return, theywill leave. It is that simple. They are neither moral nor immoral. They are amoral – and that isexactly how it should be.When national leaders have not been busy blaming money or “capitalism” – or the mostefficient way of exchanging money – for all manner of ills, they have been blaming the money“changers”. This is nothing new. National “leaders” have been doing this since before Christ.Historically, “traders” or “moneychangers” have been looked down upon by polite society fromthe time of the Romans. Thus, it was no surprise to see during the “big bangs” that took placein the 1970s and 1980s in the US and the UK that people from less privileged backgroundsgrabbed the opportunity to participate in those financial revolutions with both hands. Skillsthat were learned in the back streets of Brooklyn or the East End were every bit if not moreuseful – if given the opportunity – than belonging to the right school or club. Only when these
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individuals made enough money at trading to be noticed did that polite society pay attention,but only grudgingly. Society was not alone in looking down on such people. Governments andnational leaders did the same and always have done – and probably always will do. Thus, whenthe Prime Minister of Malaysia, Dr. Mahathir, railed against foreign exchange speculation,shouting that it should be “banned”, at the IMF meetings in Hong Kong in 1997, this shouldnot be seen as an isolated incident but part of a rich seam and history of conflict betweengovernments and traders. Mahathir is far from alone in thinking or voicing such views. Someyears earlier, after the 1993 ERM crisis, none other than the Chancellor of Germany at thetime, Helmut Kohl, was reported as saying foreign exchange speculation was an Anglo-Saxonconspiracy against the goal of a united and single Europe, presumably forgetting in the processthe origin of the word “Saxon”.When economic or financial calamity occurs, it is not surprising that governments reactagainst this, not least because they do not want to seem to be blamed themselves and thusseek to blame others. In the context of capital flows, however, there seems to be a doublestandard. Governments are usually quite happy to receive large amounts of capital inflow. It isonly when that capital starts to flow out again, putting pressure on exchange and interest ratesthat governments protest against “speculation”. From this, we arrive at a simple capital flowmodel:A buyer = an investorA seller = a speculatorThis is of course nonsense and a gross simplification of what is actually a complex issue.Nonetheless, it is an attitude that is widely prevalent among national governments. Whateverthe case, the perception that capital outflows have been behind the economic and financialcollapse of a number of countries has produced outrage in these countries. Meanwhile, it hasalso had the somewhat more beneficial effect of causing supranational organizations such asthe IMF and the World Bank, along with central banks, to spend a substantial amount of timeand effort in studying capital flows and their effect.
3.1 SOME EXAMPLES OF FLOW MODELSThe field of currency analysis has in the past few years developed a number of models totrack capital flows, the number of which has grown in line with increasing transparency ofthe available data. Most currency trading takes place in the “over-the-counter” market; that isto say over the phone between bank dealers. However, until relatively recently banks did notthink to track their own transactions for the purpose of prediction. The market was thought tobe a vast pool of transactions and sentiment, which it was virtually impossible to track. No onemodel could hope to track the entire currency market. In addition, it was doubtful that bankswould be prepared to hand over their flow data to an outside party and risk it getting into thehands of their competitors. Thus, the first flow models came from the available data at the time,either from the “open outcry” exchanges such as the New York Stock Exchange, the ChicagoBoard of Trade or the Chicago Mercantile Exchange, or from official data sources such as theFederal Reserve Bank of New York, the US Treasury or the Bank of England. For instance, theChicago Mercantile Exchange produces every week its IMM (International Money Market)Commitments of Traders report.
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3.1.1 Short-Term Flow ModelsThe IMM Commitments of Traders ReportUnlike the OTC data that is currently available, there are two major advantages with datafrom open outcry exchanges – it is available relatively quickly after the trade is made and itis transparent. The rules of the exchange concerned require not only full documentation foreach trade, but also the type of account making the trade. The weekly IMM Commitments ofTraders report collates trades made in currency futures contracts through the IMM trading pitin Chicago by various types of accounts. For our purposes, the most useful type of accountthat we are interested in is what the IMM euphemistically calls “non-commercial accounts”.In layman’s terms, this means speculators or accounts that trade currencies on their own withno attached underlying asset.Granted, the volumes that go through the IMM currency futures’ contracts pale by comparison with the regular interbank market. However, here again, the advantage is that the IMM datais transparent. Moreover, given that the non-commercial account trades represent the activityof the speculative community on the IMM, this can be used as a reflection of overall speculative activity in those currencies. Indeed, one can go further and say that precisely becauseIMM volumes are small relative to the interbank market, a notable speculative position in acurrency pair on the IMM may actually be reflective of a similar but much larger position inthe interbank market. Before going on further, it is probably useful to take a look at an actualIMM Commitments of Traders report and seek to analyse it, just as a currency analyst wouldfor their traders and clients. In Table 3.1 we present the IMM Commitments of Traders reportas of November 20, 2001.As the table shows, this report reflects the total long and short open positions that IMMspeculators have in these currencies at any one time (in this case as of November 20, 2001).This is very useful information. If a speculative position becomes too large, we know fromour work looking at the speculative cycle that it may eventually be reversed. Thus, using thisinformation, traders, investors or corporations can position accordingly to anticipate such areversal. In addition, it is a relatively simple matter to graph this against the spot exchangerate. If we accept that the speculative community’s open position in IMM currency futures is arough reflection of what it might be in the much larger interbank market, this might well giveus a much more useful picture of what are the outstanding positions in the market, and thusthe outstanding risk and vulnerability.Table 3.1 IMM Commitments of Traders (non-commercial accounts) as of November 20, 2001
Gross longsGross shortsNet positionNet positionfrom priorweekFive-year high(longs)Five-year high(shorts)
EUR
JPY
CHF
GBP
CAD
AUD
MXN
17,89918,185−286+484
13,49132,377−18,886−4,231
8,4738,234+239+5,219
3,1629,220−6,058+1,755
3,28828,663−25,375−28,089
3,729428+3,301+12
16,3931,064+15,329+14,322
31,666(28/08/01)34,328(02/01/00)
67,229(08/31/99)69,715(05/18/99)
48,332(10/19/99)54,553(05/04/99)
48,014(10/19/99)43,767(07/13/99)
46,780(11/12/96)41,327(10/17/00)
20,859(05/11/99)11,484(08/31/99)
12,641(03/20/01)4,159(07/01/97)
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From this table, we can extract a variety of specifically useful information. For a start, wecan compare the net speculative position of the week being analysed to the previous one. Inaddition, we can compare this figure with multi-year highs and lows. Moreover, if we overlaythis data with the actual spot rate, we can see how net changes in the IMM speculative positionfor each exchange rate correlate with the actual price action. To be sure, the IMM data is nota perfect representation of what goes on in the currency market as a whole, as its volumes aresmall on a relative basis and IMM-based speculators are not necessarily the same ones thatoperate in the larger currency market context. That said, the fact that one can use IMM datato generate excess returns suggests that the strong correlation, albeit with a lag, between theIMM data and the actual exchange rate price action does indeed reflect a predictive capacity ofthe data itself. A large number of banks now regularly use the IMM Commitments of Tradersreport, both as an analytical and a predictive tool for their own trading desks and for theirclients.For example, if we look at the available data we see that the speculative community hasbuilt up a substantial short yen position (against the US dollar). The base currency for theIMM data is always the dollar, thus if they were short yen futures, that means they were shortyen against the dollar. IMM net positions can of course be easily graphed, either on theirown or perhaps more usefully against the dollar–yen exchange rate. If we do that, we see thatspeculators had in fact been substantially long yen futures for October and much of November.This is also useful to know as it suggests that a potentially important trend reversal has justhappened. If we consider this as a reflection in the overall currency market, we get a picture ofspeculators having been substantially short dollar–yen (i.e. long yen) and of that speculativeshort position having been gradually eliminated initially and then increasingly reversed. Thisactually occurred in line with a move higher in the dollar–yen exchange rate, as one mightexpect as a result of the buying required to close out those short positions. One thing that canbe noticed from this example is confirmation that the IMM speculative position was indeedreflective of a much larger outstanding position in the overall currency market. After all, if thatwere not true, the closing out of the IMM position would have had no effect whatsoever on theprice action. You might think this coincidence, but the correlation between changes in IMMspeculative positions and short-term moves in the spot exchange rate is too high to be that.While the reversal in the IMM speculative position in the yen may be a notable changeand thus may last for some time, there is a further point to be made, namely that the largerthe speculative position becomes, the more vulnerable it in turn becomes to reversal andretracement. Indeed, this is entirely in line with the conclusions of our speculative cycle model,which suggests that the longer a currency price trend lasts, the more speculative it becomes andthe more vulnerable to a sharp and violent reversal. In line with this, the larger the outstandingspeculative position, the more laboured the price action becomes in favour of the prevailingtrend. This is not to say the prevailing trend cannot continue for some time. It is to say howeverthat the momentum of that trend will continue to slow as the size of the outstanding positionin favour of that trend increases. It is also to say the longer the trend lasts, the more explosivethe eventual reversal.Returning to our IMM example, looking at the dollar–yen exchange rate, the IMM data tellsus that speculators were at the time becoming increasingly bullish on the dollar vs. the yen.Here, it helps to add some fundamental explanation to the available flow information. It is akey theme of this book that analytical disciplines, which focus on the currency market, are bestused in combination rather than in isolation. That way they give a much more powerful – andtherefore potentially prof