Forex: Liquidity

Buy on the up arrows, sell on the down arrows

This tool is intended to predict exchange rate movements based on government policies, using data on monetary policy available at the time, specifically comparative real interest rates. For comparability, exchange rates have been rebased to set year-end 1994 at 100.

In each chart the currency index is shown as the thick white line on the right hand axis. The explanatory variable, domestic less foreign real interest rate, uses the left hand axis, shown as the thin yellow line. Best Guesses as to the future direction are shown as red arrows alongside the currency.

Depending on whether the investment perspective is Dollar-based or relative to a global benchmark, the relevant foreign data are those for the United States or a GDP weighted global average.

This tool works on the assumption that governments rarely make a change in policy all at once, but spread out over a number of intermediate steps, so the effects of a change create a trend over time that investors can exploit. However, in times of crisis this is not the case.

Buy signals are generated when two conditions are met - the real effective exchange rate is depressed and real interest rates begin to rise compared to international levels. Sell signals arise when the converse applies. Noise reduction methods have been employed to minimise the number of signals. Please note that this system may not catch all important moves.

Back-tested past performance of this strategy shows that it can be an effective way both to raise returns and to reduce risks.

Owing to the conversion of legacy currencies into Euros, analysis is provided on the common currency, rather than for individual countries. Historical data is provided by creating synthetic GDP-weighted time-series for the component currencies, expressed in the European Currency Unit.

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