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Thursday January 19, 2006 - 12:15:53 GMT
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Currency prediction?


“The debate between those who believe markets are always rational and efficient, resting on fundamentals, and historians who call attention to a series of financial crises going back to at least 1550 is likely to continue. Parsimony calls for making a choice for or against financial crisis; complexity permits one to say that markets are mostly reliable but occasionally get caught up in untoward activities.”

Charles Kindleberger

FX Trading

Now three-month yields are above 10-year yields. Yikes!

“For the first time in more than five years, the yield on three-month Treasury securities ended the trading day above 10-year yields, a reversal of their traditional relationship. The phenomenon is known as an inversion of the yield curve, which has often signalled economic downturns,” The Wall Street Journal reported today.

And yet we wake to another day when the US dollar is doing just fine. Obviously this game is not all about yield. Are we seeing some safe haven flow as the “Iranian situation” intensifies? Likely! Is it concern that despite the rebound in the Nikkei this morning, some of the players are returning to home base? Maybe! Is the crowd again thinking that maybe we were thinking too much about those structural things—the Double D’s of Doom (current account and federal budget deficit)—that got is in trouble last year around this time when we used it as justification to short the dollar? We have no idea.

Watching an online presentation about the forecasting ability of yet another black-box model yesterday got me to thinking about how we keep PRETENDING WE CAN predict this stuff. Said model was of the “fractal” variety, thus adding a layer of sexiness that just might likely lead to more sales. Of course model selling always begs the question: If the model is so good, why are you selling it?

George Soros sums up the difficulty of predicting very well:

“If the participants’ thinking bore some determinate relationship to the facts there would be no problem: the scientific observer could ignore the participants’ thinking and focus on the facts. But the relationship cannot be accurately determined for the simple reason that the participants’ thinking does not relate to facts; it relates to events in which they participate, and these events become facts only after the participants’ thinking has made its impact on them. Thus the causal chain does not lead directly from fact to fact, but from fact to perception and from perception to fact with all kinds of additional connections between participants that are not reflected fully in the facts.

“How does this complex structure affect the ability of an observer to make valid statements about the course of events? His statements must also be more complex. In particular, they must allow for a fundamental difference between past and future: past events are a matter of record, while the future is inherently unpredictable. Explanation becomes easier than prediction.”

You gotta love that! Of course assuming you are not the type who believes models, especially your own, have predictive power. We likely need a bit more work on our fractal mathematics before we can play the predicting game—though we don’t deny there is likely something there.

Most seasoned strategists have made quite good living on the Street and among the FX blah…blah…blah…circuit knowing how this game is played. It’s no matter that they don’t know the causal relationships in the currency markets—there are so damn many possibilities—it only matters that they use the proper analyst-sounding terminology and do it with confidence. (That is of course the role we try to play each day here in this letter. The difference is that our stuff usually has an implicit warning label that reads: We really have no clue…this is our best guess…if it’s correct, we consider ourselves lucky. It’s simply a probability game.) Does that make us feel superior to those without warning labels? No. Because without them we would have no one there to take the other side of trades we often like.

“Explanation becomes easier than prediction,” said Soros. Ain’t that the truth!

Jack Crooks
Black Swan Capital


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