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Tuesday July 5, 2005 - 11:09:30 GMT
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Dollar "overshoot"? Not yet!


“If you are going to use probability to model a financial market, then you had better use the right kind of probability. Real markets are wild.”

Benoit Mandelbrot, The Misbehavior of Markets

FX Trading

As we watch the British pound get hammered lower—lurching from so-called “oversold” to “more oversold”, some are growing concerned that he dollar is “overshooting.” We turn to Mr. George Soros, and his theory of reflexivity—or boom/bust—as a guide to determine just how close we are to “overshoot” territory.

Reflexivity, as described by Soros seems a very good model for currency market behavior.

Two generalizations that are at the core of this theory/model:

1) Prices have some effect on the fundamentals

2) There is a flaw in the participants perception of the fundamentals

What is the flaw in perception? And how and when is it likely to occur? These two questions represent the key to understanding when its time to switch sides—and play for a trend in the opposite direction.

In the case of the dollar, we have already seen the boom/bust process play out against the euro. It seems all the stages of the boom/bust sequence, as defined by Soros, were there:
First a look at the stages in the boom/sequence as defined by Soros:

1) The unrecognized trend
2) The beginning of a self-reinforcing process
3) The successful test
4) The growing conviction, resulting in a widening divergence between reality and expectations
5) The flaw in perceptions
6) The climax
7) A self-reinforcing process in the opposite direction

As the dollar was edging toward its low, late last year, we believed the flaw in perception was the focus on the current account deficit to the exclusion of the other fundamental drivers of the dollar: yield and growth. We believed that then, and we believe it now.

With the gift of hindsight, it seems clear that the gap between expectations about the euro becoming the world’s new super currency versus the fundamental reality of a deteriorating underlying superstructure supporting these expectations was much too wide to support. Thus, we reached stage 6) in the sequence—the climax—in late December of last year, when the dollar bottomed and the euro peaked near 1.36. Early in the year a self-reinforcing trend in the dollar developed Stage 7) and was only noticed by a few diehards like us, as Stage 1) of the unrecognized trend began.

Now, the question is: Where are we along this sequence with dollar? Some believe we are nearing “overshoot” territory—which starts at stage 4)—“widening divergence between reality and expectations.” Though we may be entering Stage 4), it is difficult to define how long it takes to reach the final stage in the sequence, Stage 7).

We think this dollar move has much more to go. Clearly, the expectations concerning the positive dollar yield and economic growth differential does not seem flawed, as the pressure for ECB and Bank of England rate cuts grows, and falling demand and rising unemployment in Europe seem to be intensifying.

We don’t believe we will be entering “overshoot” territory on the dollar until we have witnessed another of our themes being played out: risk capital returning to the US shores driven by disappointment flowing from China. This disappointment could come in the form of: a) a final “No” on revaluation of the yuan anytime soon, or b) a realization that demand for industrial materials and commodities is slipping as Chinese growth slows and domestic supply increases, or c) a real estate bust in Shanghai.

“Speculative capital moves in search of the highest total return. Total return has three elements: the interest differential, the exchange rate differential, and the capital appreciation in local currency,” according to Soros.

The dollar seems to have all three elements of total return going its way at this stage. So, we would have to conclude the path of least resistance for the buck is up—and it could be for a lot longer than the players would care to believe.

Jack Crooks
Black Swan Capital


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