Between the years 2000 and 2010 there were some massive fluctuations in the currency markets. Some currencies saw dramatic rises, while others fell just as precipitously. This was not isolated to emerging economies, but it did affect the world’s reserve currencies and largest economies on the planet. Mammoth trends in currencies play a major role in how individual lifestyles and how companies and countries conduct business. In the last decade, Canada, Japan and the Eurozone all saw major moves in their currencies relative to the U.S. dollar. The mega-trends within these liquid currency pairs can be broken down into factors that resulted in the moves.

Throw Out the Financial Theories

Exchange rate movements have proved to be exceedingly hard to predict using financial theories such as the purchasing power parity (PPP). In a 1983 article produced for the National Bureau of Economic Research, Richard Meese and Kenneth Rogoff found that no structural or time series models could effectively produce better forecasting results than a random walk, and the more future expectations were built into current prices, the harder prices were to predict. (Learn more about the random walk in our Financial Concepts Tutorial )

While the study is intriguing, market participants must realize there is an extreme amount of noise in financial markets and often there are definable reasons for the dramatic moves in exchange rates, such as those seen from 2000 to 2010.

On an international scale, a currency is often defined as a way to exchange goods and services between countries with differing economies. Yet currency values determined by a free market, which is open to multiple players with differing opinions and motives, means that actual trade fundamentals and economic data can get pushed aside. According to the Bank for International Settlements. in April 2007 the foreign exchange markets did, on average, $3.2 trillion per day in transactions. Compared to the total of all world trade done in 2006 — $12 trillion — the actual trade data is dwarfed by speculation, which accounts for about 1.4% of currency transactions. Unprecedented speculation may be a major determinant of mega-trends, as positions are entered/exited by more and more participants. (Refer to What Is The Bank For International Settlements? for more information on this bank)

When we realize that a theory based on trade is unlikely to predict currency markets, other strategies can be employed.

Three methods can be used to help determine the direction of a currency and explain the mega-trends that have occurred in the decade in question. All three can be looked at to help paint a picture of what has occurred and what may occur. The three work together, feeding into and off of each other.

Method 1: Bias in One Currency Compared to a Basket of Others

While country-to-country comparisons are useful, in terms of exchange rates, much can be explained by a pervading bias in one currency versus a basket of others. When one currency is compared to a basket of other currencies, the performance within the basket can partially explain movement within specific currency pairs. The U.S. dollar is a trending currency. As the world’s reserve currency. it goes through long-term trends that affect the exchange rates of individual countries. Those countries also have tendencies, which may include ranging or trending tendencies. For example, the dollar index can provide a broad context for trading that occurs within U.S. dollar related pairs. While individual pairs may deviate from the trend, Figure 1 and Figure 2 show that as the dollar index fell, so did these liquid individual pairs. This is logical, considering individual pairs compose the index, but the index provides a broader view. (For more information on the U.S. dollar, see The US Dollar’s Unofficial Status as World Currency .)

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