The increased influece of equity markets on currency forecasting techniques

Introduction 
3 
 
1.1 Exchange rates forecasting 
Forecasting foreign exchange rates is an important, but difficult process for financial 
executives of multinational corporation, for investors and traders of foreign exchanges in 
foreign exchange markets and for governments’ foreign exchange policies. It is important 
since the foreign operations of multinational corporations are subject to the impact of 
foreign exchange risk that arises from changes in foreign exchange rates, since the 
exchange investors and traders may profit from shifts in exchange rates, and since 
governments’ exchange policies may exert substantial effects on foreign trade and, 
possibly, interest rates. It is difficult because of the potential for periodic and, perhaps, 
unpredictable government interventions that make currency forecasting all the more 
difficult. 
At the simplest possible level, an exchange rate is the domestic currency price of 
foreign currency, in terms of elementary microeconomics, determined by supply and 
demand. The upward-sloping supply and downward-sloping demand curves are 
reassuringly familiar, however interpreting them seems nowadays to be difficult for most 
of the analysts. 
At the start of last year, almost all the forecasters predicted that the Euro would climb 
against the dollar, and that the Yen and the Pound would slide. But the opposite 
happened: the Euro felt sharply against the Dollar, and the Yen and the Pound have risen. 
Traditional models used to forecast currency seem to have developed a serious fault. 
Having seen their old tools break down, some forecasters are turning to newer models. 
Behind most exchange-rate forecasting models is the idea that currencies have an 
equilibrium level to which they will eventually return. Awkwardly, however, economists 
find it difficult to pin down the factors that determine that equilibrium level; indeed those 
factors have probably changed. Trade in goods and services was once the linchpin. Then 
Introduction 
4 
bond markets became more important. Now, some say, equity markets are increasingly 
the main force steering exchange rates. 
 
 
1.1.1 Overview of traditional techniques  
The oldest theory of foreign-exchange equilibrium is purchasing-power parity. This is 
based on the notion that, in the long run, exchange rates should move to a level that 
makes a basket of tradable goods and services cost the same in any two countries. 
Considering dollars and marks as examples and ignoring the difficulties associated 
with expectations and perceptions of monetary policy, the dynamics underlying the 
dollar’s depreciation might proceed as follows: faster money growth creates inflationary 
pressures in the United States, causing people to shift their purchases away from U.S. 
goods toward the now less expensive German goods. To acquire German goods, however, 
people must first convert their dollars to marks. The increased demand for marks (and the 
grater supply of dollars) will bid up the value of the mark relative to the dollar in the 
foreign exchange market; that is , the dollar will depreciate against the mark. Holding 
other things constant, this dollar depreciation will continue as long as the U.S. inflation 
rate exceeds the German inflation rate, and will tend to match the inflation differential 
between the two countries. If, for example, Germany’s inflation rate is 2 percent per year 
and the U.S. inflation rate is 3 percent per year, the dollar will depreciate 1 percent per 
year against the mark, other things being equal.  
The explanation above contains two important implications for monetary policy: first, 
because monetary policy ultimately determines only the domestic inflation rate, a central 
bank that wants to engineer a depreciation of its currency must create more money than 
its trading partners and thereby generate a higher inflation rate. Second, because any 
resulting exchange-rate depreciation will ultimately offset the inflation differential, a 
Introduction 
5 
monetary-induced depreciation can not secure a competitive trade advantage. The real 
exchange rate will remain unaffected in the long term. Any trading gains from 
engineering a currency depreciation are purely transitory, lasting only until prices fully 
adjust. Recent estimates suggest that once disturbed, purchasing power parity takes an 
average of eight years o become reestablished
1
. 
One interpretation of this finding is that goods prices adjust slowly to monetary 
shocks, implying that monetary policy may be able to affect the real exchange rate in the 
interim. A second interpretation is that non-monetary events, such as productivity shocks 
or changes in preferences for domestic versus foreign goods, are important determinants 
of exchange-rate movements. 
A second, related concept of equilibrium is the exchange rate that is required to 
achieve current-account balance.  
By assuming that world inflation rates and expectations are constant, we can focus on 
the real component of the nominal exchange rate. This will change in response to any 
economic event that affects the real (inflation-constant) demand for, or supply of, traded 
goods and international investments. To understand the connection, however, one must 
first understand balance-of-payments accounting. 
The balance of payments records all transactions between instate residents and 
residents of the rest of the world. A country that incurs a current account deficit is 
consuming more of the world’s output than it is producing. Its imports are a debit item in 
its current account, creating a supply of its own currency. Such a country must pay for its 
extra current consumption (that is, its surfeit of imports) by giving foreigners financial 
claims on its future output (stocks, bonds, bank deposits and so on). The resulting foreign 
capital inflows are credit items in the balance of payments and represent a demand for 
                                                     
1
 See Kenneth A. Froot and Kenneth Rogoff, “Perspectives on PPP and long-run real exchange rates”. 
Introduction 
6 
home currency. Current account and capital account balances must offset each other 
exactly (assuming that everything is measured correctly).  
The capital account does not passively respond to the current account, as the previous 
paragraph implies. Myriad individuals make separate decisions about importing, 
exporting and investing abroad, and each of these decisions affects the balance of 
payments independently. If at any time the collective intentions are not consistent with 
equilibrium in the accounts, attempts to enact these plans will cause the real exchange 
rate to change. The exchange-rate adjustment in turn forces people to reevaluate their 
plans in such a way as to pull the current and capital accounts into balance.  
If an overvalued currency falls towards its purchasing power parity, this should help to 
reduce a trade deficit by making exports cheaper and imports more expensive. However, 
if an economy as large debt-service payments as a result of years of current-account 
deficit, as in the United States, it will need to run a trade surplus to balance its overall 
current account. So its equilibrium exchange rate may, for some time, be below the 
purchasing-parity level. The Fundamental Equilibrium Exchange Rate is based on this 
approach: it is the exchange rate that produces a “sustainable” current-account balance. 
Introduction 
7 
 
1.2 The financial markets role 
Both purchasing-power parity and Fundamental Equilibrium Exchange Rate focus 
mainly on the prices of traded goods and services. That was fine when tight controls 
restricted the movements of capital around the world. But now that those controls have 
been largely scrapped, capital flows have become more important and trade in 
determining exchange rates. Despite America’s huge and growing current-account deficit 
in recent years, the Dollar has being strong because foreign investors have being happy to 
finance that deficit. On this view, the relative prices of financial assets in different 
countries matter more than the prices of goods. Investors will shift funds until expected 
returns are higher, or expected risks lower. 
The current price of an assets reflects the present discounted of the income stream that 
investors expect it to generate over its lifetime. Similarly, an exchange rate reflects the 
present discounted value of all relevant fundamentals, including current fundamentals and 
their expected future values. Foreign exchange traders face strong incentives to acquire 
every piece of information about current and anticipated economic developments that 
could possibly influence exchange rates. If these dealers are successful, their current 
quotations will incorporate all available, relevant data, and only new information that 
causes revisions in traders’ expectations will influence exchange rates. This implies, for 
example, that previously anticipated changes in monetary policies or other fundamentals 
will not affect current exchange rates; only unanticipated changes will. 
One might expect profit-seeking exchange dealers to formulate their expectations, and 
therefore their exchange quotations, without making systematic errors. To the extent that 
they can do so, revisions to their quotes will be fairly random and will impart a zigzag 
pattern to exchange-rate movements. Over time, a net change in one direction or the other 
Introduction 
8 
may emerge as exchange rates adjust to persistent shifts in underlying fundamentals. On a 
day-to-day basis, the exchange rate will bounce around any such path. 
The fore going discussion is based on the implicit assumption that expectations are 
fairly uniform and remain firmly anchored to a set of generally recognized fundamentals, 
but many evidences conflict with it. The aforementioned poor performance of exchange-
rate models, for example, undermines the validity of this assumption. Particularly 
damaging is the fact that since the inception of floating exchange rates, both nominal and 
real exchange rates have increased substantially, but the volatility of their underlying 
fundamentals has changed little
2
.  
Although exchange traders are highly effective users of information, they probably are 
not perfectly efficient. Indeed, why would trade occur, especially in such large volumes, 
if all traders had identical information at all times? For one thing, information about 
economic fundamentals (both its acquisition and its interpretation) is costly, which may 
explain why many foreign exchange traders generate profits from technical trading rules, 
instead of from models based on economic fundamentals. Many of these rules project 
past trends into the future. 
 
                                                     
2
 See Jeffrey A. Frankel and Andrew K. Rose, “Empirical Research on Nominal Exchange Rates” 
Introduction 
9 
 
1.2.1 Financial assets evolution 
Until recently, the financial assets involved in the exchange rates forecasting were 
largely government bonds. International money tended to move in response to differences 
in bond yields. Now, however, some economists reckon that equity markets are 
increasingly in the driving seat. In the past year or so, there has been a strong correlation 
between the Dollar and the American stock-market. A net inflow of equity capital into the 
country has supported its currency. In contrast, the net outflow from the Euro zone has 
more than offset its current-account surplus, depressing the Euro. Equity markets have 
become more important for  two reasons. The first is that they have grown rapidly 
compared with government-bond markets. In 1990 America stock-market capitalization 
was only 50% bigger than the stock of Treasury bonds. Today the value of equity is four 
times as large
3
. This is partly due to higher share valuations, but it is also because the 
government, now in surplus, is issuing fewer bonds.  
The second reason is that cross-border equity investment has increased even more 
dramatically. When they ventured abroad, investors used to buy government bonds 
almost exclusively. Now they are increasingly buying equities. In the 1990 foreigners’ 
dealings in American Treasury bonds were ten times bigger than their equity transaction. 
By the end of 1999 they were less than twice as much, and these figures do not include 
mergers or direct investment. 
There have also been good economic reasons for the Dollar to move in step with 
American shares. The spurt in productivity growth in America has pushed up share prices 
in anticipation of future productivity gains, and also improved the competitiveness of 
American goods, thus increasing the Dollar’s long term equilibrium level. 
                                                     
3
 Source: Warburg Dillon Read 
Introduction 
10 
 
1.2.2 Gambling on forecasts? 
Going through some of the most recent literature about exchange rate forecasting, I 
found out that there was anyone of any repute that predicted the decline of the Euro from 
its inaugural level of $1.17 to $1.18 two years ago. The question then is why. All the 
traditional models having to do with relative growth rates, exchange rate differentials, 
capital flows, do not seem to provide any kind of credible explanation as to what is going 
on.  
Fred Bergsten and Rudi Dornbusch are two well known economists who were recently 
interviewed by David Folkerts-Landau on this topic. I would like to report this interview 
to show the existing uncertainty about the subject: 
Fred Bergsten 
“Well, I certainly did not predict the weakness of the Euro, but that does not stop me 
from fearlessly predicting that it will rebound very sharply and go back to its opening 
level or even beyond within the reasonable future, perhaps the next year or two. We here 
at the Institute pioneered a concept a number of years ago called Fundamental 
Equilibrium Exchange Rates, where we try to estimate the long term value of a currency 
that is sustainable in the markets. Over time, that approach has a very good track record 
predicting where exchange rates will go. Our prediction for the Euro is somewhere 
around $1.25. so we would expect to see a rebound of 25 to 30% for the Euro over the 
foreseeable future. I note, incidentally, that the International Monetary Fund, which has 
adopted and replicated our methodology, has publicly said the same thing just in the last 
couple of weeks. Why has the Euro been weak? I differ a little bit, David, from what you 
have said in that, I think the growth differentials compared with expectations probably are 
a factor. A big surprise in 1999 was how rapid US growth was. US growth was expected, 
but most forecasters thought US growth rates would be much lower than where they came 
Introduction 
11 
in. That provided not only firmer monetary conditions in the United States, but also better 
growth prospects and better profit prospects, and that was extremely bullish for the 
Dollar. Now a puzzle to many. 
Another key factor was the way in which the Euro became almost immediately a very 
popular currency for borrowing, but not for holding. The Euro market, in fact, exceeded 
the Dollar market for international bond flotation in 1999, so there were a lot of Euro 
being created on the supply side. But most of the people who borrowed Euro to take 
advantage of lower interest rates and other factors, did not hold onto them, converted 
them into Dollars and to some extent other currencies. And so what you got was an 
increase in the supply side that was certainly not matched on the demand side. That too 
depressed the rate. I think there were other factors having to do with perceptions of 
European policy, the cacophony of voices coming out of Frankfurt and the new European 
Central Bank. But I would point to those two as the main reasons that the Euro has been 
so weak and why I think it will turn around in the fairly foreseeable future”. 
Rudi Dornbusch 
“Well, Fred has said a lot. And I think some of these things are right. I think Europe 
looks pathetic, and the US looks wonderful. And that was the surprise, as Fred said, and 
that is going to continue to be the case, because Europe was coming apart. We are waiting 
for US to have a really bad bubble burst, a hard landing. And in that setting, Europe, with 
its quiet stability, would look attractive again. And what we are finding out is that the 
bubble bursting is not happening here. There is a lot of stability, a lot of stabilizing 
speculation, a deep sense that this story is good lasting and stable. A slowdown to three 
percent, that is what we call slowdown. In Europe it is called a boom. And that 
discrepancy, I think, will last, and that is what the current sell off is about. The news that 
in the US, bubble bursting is not going to happen. What will turn it around? I do not see 
that we are going to have a major rally in the Euro in the next year. Or even two. And i do 
Introduction 
12 
not believe we will get to $1.25. The US economy is deeply stable. On the fiscal side, on 
the inflation side we have a bump, they have a bump. Our bump is a little bit bigger than 
their bump, but it is not going to bring down asset markets. And in the stock market, I 
think people believe these companies are good, that they have high growth, that 
recessions will not happen anymore, because we are paying early attention to inflation 
issues. Europe is going slow, slow, slow, and in the US the everyday discovery is that 
there is more of it, and it is a big stabilizer in asset markets. So I would not believe that 
we see $1.25 as the exchange rate, Dollar-Euro, in the next two years. Some rally I can 
easily imagine. But after ten percent, I would say: “This is it”. Just as I can believe the 
stock market will sell off some more. But meltdown? Forget it. On the fiscal side, on the 
inflation side we have a bump, they have a bump. Our bump is a little bit bigger than their 
bump, but is not going to bring down asset markets. 
Introduction 
13 
Fred Bergsten 
“Let me come back if I might and explain why I come out where I do. I agree with 
Rudi on the strong underlying performance of the US economy, it is tripled, and I think it 
may still in the early stages of commercializing new technologies, taking advantage of 
globalization and all that. 
Having said that, there is one huge imbalance in the in the US economy, and that is the 
external position. The current account deficit has hit $400 billion at an annual rate. It is at 
four percent of GDP. It is rising further and it is on a trajectory getting to levels that I 
think in terms of all history of the US itself, of all industrial countries, even of emerging 
markets, is at a level that is really dangerous territory. And if the history of this business 
suggests anything, it is that within a reasonably finite period of time, the external 
imbalance will lead to a sharp decline in the exchange rate of the Dollar. 
Here, I am also relatively optimistic. I think it will be a soft landing, not a crash, not a 
hard landing. But I think it will be substantial. Keep in mind that the Dollar already came 
down 30% against the Yen two years ago. In that sense, you might say that the first leg of 
the Dollar correction has already occurred. I think we will get a similar leg against the 
Euro. 
What would trigger it? One thing would be a significant slowdown of the US 
economy so that the differentials move against the Dollar, not in favor. Remember that 
what counts is not differentials in absolute terms, but changes in differentials relative to 
anticipations. And if there is a significant slowdown of the US economy, with some 
easing of US monetary conditions, particularly accompanied by a further pickup in 
European growth rates, then I think a second factor kicks in. I continue to believe that 
over the long run the Euro is going to become an important international currency and 
move up at least to rival the Dollar for international currency usage. People have not 
moved into the Euro yet because obviously it has been weak and it has been a bad bet. 
Introduction 
14 
But once it begins to strengthen, my sense is that some of that long-term portfolio 
diversification will begin to take place, so you will get a double-barreled series of 
motives for accelerating and appreciating the Euro. And in fact, to relate to some of 
Dornbusch theory, I could even see the Euro overshooting on the upside as it appreciates 
over the next year”. 
Rudi Dornbusch 
“As they say: “Your words in God’s year”. For the moment, Euros are coming out of 
people’s ears, so first, things have to happen for people to grow into those positions. And 
just to give up trying to liquidate them. Europe is going to slow down next year. The 
extra stimulus for the big depreciation that has already happened is not going to be there 
anymore. And I think that Europe will see a slowdown that will look more difficult than a 
US slowdown. The US going to three percent is healthy, Europe slipping from three on 
down… 
David Folkerts-Landau 
“That is going against the consensus forecast!” 
Rudi Dornbusch 
“Sure. So the IMF is going to be wrong. What is driving European growth right now is 
the real depreciation of the past year. That is this year’s food, and next year there is not 
going to be extra. And will look worse than the US slowdown, which is necessary 
because of the boom. The Euro is not an American problem, the Dollar is our money, and 
it is their problem”. 
David Folkerts-Landau 
“Rudi, when I was listening to you earlier, you seemed to be suggesting that much of 
the Dollar’s strength in the recent year has come from capital inflows, foreign direct 
investment, plus flows into the US fixed income market and then some hot money on top 
of that. That would suggest thought that if there is a change in sentiment in US equity 
Introduction 
15 
valuations, for instance, we could in fact see Fred’s scenario come true: a very rapid 
change in the Dollar on the way down”. 
Rudi Dornbusch 
“We have had a test case of it in April, and the conclusion from it is, it does not kill 
the Dollar. And the next conclusion: “Boy, that was the story for the Euro to turn”. The 
story is gone: down the Euro. So I think you have to believe in the US. The landing is 
going to be much softer, and it is much softer, it is not a place to run away from. This is 
not over. I think the US will continue to have a strong currency, the current account 
deficit may well come down from the slowdown of growth, and this story could go on for 
three or four years. There will be a day when the Euro rises. But let’s not rush it.” 
David Folkerts-Landau 
“Let us just take that observation for a moment. When you talk about this long-term 
equilibrium value for the Euro, you say there will be a day when it rises. You also 
concede that it might go to $0.85 and then come back up to $0.95 and its equilibrium 
value. When you say it rises, does that imply that it is currently undervalued based on 
fundamentals?” 
Rudi Dornbusch 
“I do not think it is undervalued. I think Europe has a pathetic supply side. I think the 
current account is totally exaggerated as a determination of exchange rates over a ten, 
fifteen years period. The central bank looks after inflation and unemployment, and not the 
current account. My long-term outlook for the Euro would be $1.00. As sort of a good 
round number”. 
Introduction 
16 
Fred Bergsten 
“No, I think that would substantially overvalue the Dollar and undervalue the Euro. 
On a long-term basis. I Would actually dispute what you implied a minute ago. I think 
over the long run, the current accounts actually give a pretty good guide. Once past the 
November election, and maybe even before that, I think that the US will be reluctant to 
see more Dollar appreciation. They know it is going to trigger huge trade protection once 
the economy slows down and unemployment begin to rise, and store up the prospect for a 
sharp Dollar fall a la mid-1980s, when luckily it did not cause huge problems, but it came 
very close in 1987”. 
Rudi Dornbusch 
“Euro-Dollar is not a protection issue. Nobody cares about it. The Dollar-Euro 
exchange rate appears in the social column, where people discuss whether you should go 
to Paris or not. The Yen in Asia is a protection issue. The Euro just is not. Larry Summers 
does not sit there every afternoon adding up the current account deficit. He looks at the 
stock market. That is the safe landing that is really important. And the outburst of 
protectionism: “I would worry China and the WTO. BMW is here, I think that is sort of 
not really very exciting. A current account deficit is really good”. 
Fred Bergsten 
“As long as it lasts. Historically we have never had a current account deficit in excess 
of four percent of GDP for very long without a significant Dollar adjustment. Is that not 
correct? 
I think there is some concern about the volatility, but I do not think at the moment 
there is any active consideration of changing the regime to reduce it. I personally think 
that is a mistake. I advocate target zones or reference ranges or some other method to 
limit, not so much the volatility, but the big misalignment where the rates persit out of 
equilibrium for long periods”. 
Introduction 
17 
Rudi Dornbusch 
“It was two percent. And now it has been revised up to four percent, right? 
I do not see a chance that the US administration will go back to currency markets and 
put themselves in the hands of the Japanese and European central bank what should 
happen to interest rates here. We think they are totally incompetent, and we do not really 
have the sense that these exchange rates are a problem.” 
Fred Bergsten 
“If a could just clarify two factual things. Rudi say no one believes in equilibrium 
exchange rates; the IMF does”. 
Rudi Dornbusch 
“The management level and the head of research think it is useless”. 
David Folkerts-Landau 
“One final question, Euro-Dollar at year end: where will it be? Let’s say December 
15th”. 
Fred Bergsten 
“I think it would be about at $1.10”. 
Rudi Dornbusch 
“One”. 
To some extent, the point that should be made here is that we have two of the most 
eminent commentators on exchange rates disagreeing about the value of one of three 
major currencies by as much as 30%-35%-40% even. This is the unsettled state of 
thinking in the exchange rate literature and the exchange rate forecasting.