A reasonable person could ask why the currency market would not react more rapidly to very different money supply growth rates. After all, if you create more dollars, shouldn’t every one be worth less, all else held equal? The answer lies in anticipated returns. If the money supply is growing because of increased bank lending and other extensions of credit, the underlying economy should be stronger and assets denominated in that currency should have a greater return.

We can check this by comparing U.S. and European stock indices. Let’s compare the very broad Russell 3000 index to the Morgan Stanley Capital International Euro Index. The pattern has been clear and distinctive: The relative performance of the stock indices leads the movements in the currency and the periods of out performance coincide with the periods of more rapid money supply growth. As the respective central banks relax their policies and as the respective commercial banking systems create new credit, the expected returns on assets increase. This makes the easy-to-follow returns of broad stock market indices a good leading indicator for the DXY.

This begs the question, of course, as to what drives the interest-rate expectations embedded in the money market curves. The answer, unsurprisingly, is money. The U.S. money supply (as measured by M2) grew far more rapidly than did its European counterpart from late 1999 through late 2002, a period of EUR weakness. Once the American economy started to recover after the bear market lows of October 2002, the situation reversed: European M2 growth greatly outpaced that of the U.S. all through 2005. As a result, the EUR weakened and the EUR’s FRR increased relative to the USD’s FRR.

We can link the maturity-dependent interest-rate gaps back to the movement of the EUR by using the forward rate ratio (FRR). This measure is constructed by taking the forward rate between six and nine months — the rate at which you can lock in borrowing for three months starting six months from now, and dividing it by the nine-month rate. The more this ratio exceeds 1.00, the looser monetary policy is expected to be. Critically, these forward-rate ratios are comparable across economies and across interest rate levels.

We can compare these FRRs of the USD and EUR to the three-month yield spread. While the USD’s FRR had been consistently higher (steeper yield curve) than its EUR counterpart since mid-2001, this relationship has reversed. For the first time since 2000, a period of great weakness for the EUR, the USD’s FRR exceeds that of the EUR. This is dollarbullish: It is not the absolute interestrate differential that is critical for an exchange rate’s movements, but rather the relative monetary policy expectations as measured by the shapes of the two money-market curves.

Despite the temptations to do so, we should not analyze currency markets as a kind of morality play. Nor are they some sort of international report card on how various governments are performing in their various tasks. A spot exchange rate and its associated forward market balances the expected inflation differential and the expected return on assets between two economies — nothing more and nothing less. This holds true for individual currencies and it certainly holds true for the DXY.

At the very broadest, and over a long period of time, we can correlate the DXY with the movements of the target federal- funds rate. This comparison is only part of the equation (we will drill down to some key differentials shortly), but it is instructive nonetheless. The DXY’s course follows the fed-funds rate with the usual long and variable lags associated with monetary policy.

We can repeat the exercise and analyze the dollar in terms of the federal budget deficit as a percentage of GDP. The idea here is that an increasing percentage of each additional dollar the federal government borrows must come from foreign investors. As American dependence on foreign borrowing increases, so too does the potential for moral hazard: We can drive the value of the dollar down and repay our creditors in increasingly worthless currency.

For a relationship to be causal, it must work at all times and in all market conditions. However, it shows the deepening of the federal deficit in the late 70s and early 80s both led and coincided with the surge in the DXY. The deficit’s small retreat in the late 80s both led and coincided with dollar weakness. Finally, the narrowing of the federal deficit and its move toward a surplus during the 90s led an eventual move higher in the dollar by too long of a period — more than three years — to be causal.

“Never let the facts get in the way of a good story” might be good advice in journalism, but it is inexcusable in the financial markets. How many other fields have such a wealth of readily available facts? Yet market myths and legends abound. Consider the primary one about the U.S. dollar — that its long-term depreciation is connected to the so-called “twin deficits” of the current account and the federal budget. But is there any evidence supporting this conclusion?

Let’s slay one dragon at a time here, beginning with the current account deficit. The current account, reported quarterly as part of the gross domestic product (GDP) statistics, includes the monthly merchandise trade deficit as well as trade in services and official transactions. Because the U.S. tends to be a net exporter of services, this number is a more complete and accurate measure of the U.S. external balance. Many people believe a strong dollar leads to deeper current account deficits as a percentage of GDP, and that a weaker dollar either reduces this deficit or leads to a surplus. However, It shows just how weak the relationship between the dollar index (DXY) and the current account deficit has been since the start of the floating exchange-rate era in the early 70s.

The dollar’s early-80s surge certainly preceded a deepening of the current account deficit — but that is not the direction of causality assumed by those who would have you believe a deeper current account deficit causes a weaker buck because it puts excess dollars into world markets.

Has this happened? Hardly. The deepening deficit of the mid to late 70s preceded a surge in the DXY, and the narrowing deficit in the late 80s preceded a further weakening in the dollar index.

Most telling, though, is the post 1991 pattern. The U.S. recorded its last quarterly current-account surplus in the immediate aftermath of the Persian Gulf War, on the basis of foreign government contributions for that war effort (the last month of a merchandise trade surplus was April 1976). Since then the current account deficit has continually deepened, but the DXY weakened between 1992 and 1995, strengthened between 1995 and 2001, weakened again into the end of 2004, and strengthened in 2005.

This would strongly suggest currency traders look elsewhere for what drives the dollar.

Can the conclusion that a stronger CNY does not exert upward pressure on reported inflation in the U.S. be confirmed over a longer period of time and across a wider spectrum of currencies? After all, the revaluation of the CNY should not be confused with the movements of a freely floating currency, and the process has been underway only since July 2005.

If we map the year-over-year changes in the dollar index on an inverse scale against the year over year changes for the CPI and PPI, we find only a weak leading relationship. A weaker dollar leads changes in the CPI by eight months and changes in the PPI by nine months, on average. However, the respective r2 values of 0.003 and 0.035 are statistically insignificant. No link between the dollar index and reported inflation can be asserted over the long-term. However, this statement would not have been made prior to the turning point in the dollar’s early-1980s strong period.

The dollar index’s rally started to reverse in February 1985, as marked with a magenta vertical line. Prior to this reversal, the r2 values for the rates of change of the PPI and CPI, respectively, against the rate of change for the dollar index were 0.226 in both cases. After February 1985, the respective r2 values fell to 0.0002 and 0.0368. An F-test of these regressions to determine whether they were statistically different before and after February 1985 confirmed they were at near 100 percent confidence.

What changed? This was the beginning of central bank coordination of monetary policy and efforts to drive the dollar both lower (the September 1985 Plaza Accord) and higher (the February 1987 Louvre Accord). Once central banks realized independent monetary policies could not affect short-term interest rates and currency rates simultaneously, they turned away from direct currency management and toward national monetary policies. To the extent these policies matched — and they often did currency rates could stay relatively static while inflation rates diverged. The opposite could be obtained as well; consider the Federal Reserve’s willingness to accept greater inflation in 2003-2004 while the dollar fell.

Restated, a central bank can fix its short-term interest rates or it can manage its currency, but it cannot do both simultaneously.

Those who continue to believe in the inflationary consequences of currency changes are viewing the world through the pre-1985 prism of non coordinated central bank policies. Until and unless the era of central bank coordination ends, we should expect the disconnection between currencies and inflation — and between the CNY and American inflation, both expected and reported — to continue.

Any rescue of the stock market, let alone global markets, was never the Fed’s first goal — even if the Monday crisis did influence its timing. Its real goal is to keep longerterm rates at a yield that represents good value to global investors.

Stock market meltdowns are bad for bonds in this regard. Flight capital raises prices and depresses yield. From a peak of 5.251 percent last June 14, the yield on the 10-year T-note sank to less than 3.25 percent on Jan. 22 as the global stock market crisis unfolded. Because the fed funds rate was at 4.25 percent at the time, this represented a special type of yieldcurve inversion. Even after the Fed cut rates 75 bp, the fed funds was still yielding more than the 10-year Tnote.

Equally important, headline CPI inflation in November was 4.1 percent. The implication is the 10-year bond is delivering a negative real return, with “real” meaning “after inflation”. The all time Treasury-yield low is 3.083 percent from June 2003. The correlation between yield and the dollar index is far from perfect—you get a better correlation using the yield differential with the German Bund, for which data is not readily available. But the connection is pretty clear: The dollar falls as yield falls. Bond traders call that a rally because as yield falls, prices rise. However, if you are a foreign investor — and the U.S. depends increasingly on foreign investors in Treasuries — you may be gaining with one hand (bond price) but losing with the other (currency level).

Just as we cannot expect a stock market decline to stop on a dime, we can’t expect a bond market rally to stop on a dime, either.

Bond yields stop falling when several conditions are met. First, the recession has actually arrived and its end is in sight. Second, the central bank is perceived as having reached the lowest short-term rate it will tolerate. Third, inflation fear overcomes recession fear.

Because the financial sector has a long way to go to disclose all the ugly news about losses on badly packaged and improperly rated debt, we can’t expect an end to the stock market drop and the bond market rally until the end of the first quarter after all companies have reported. And since we can’t trust what financial institutions are telling us, the end probably will not come until the end of the second quarter (June).

We should assume the Fed wants the 10-year bond yield to reflect a basic rate of return, historically 2.5 percent, plus a premium for expected future inflation, say 2.70 (based on the TIPS spread with regular Treasuries), or 5.1 percent. When the actual yield is down around 3-3.25 percent, the only reason for foreign investors to buy U.S. paper is fear that other paper (such as foreign stocks) is worse. This is not a healthy reason to be on the receiving end of foreign capital inflows, and it opens the U.S. to a charge of “manipulating” global capital markets even though the Fed has no actual control over anything other than short-term rates.

Critics are sure to say the Fed was in panic mode by cutting 75 bp on an inter-meeting basis. But in light of its true goal of lightening the inflow to Treasuries, and thus preventing the yield from falling to ridiculous (and unsustainable) low levels, it was doing the world — and the dollar — a favor.

While some in the financial world have argued that currency devaluing is a fundamentally flawed idea, there is perhaps some evidence that a quick shift to a low-rate environment has worked — right here in the U.S.

Think back to the post 9/11, post Nasdaq collapse recession in 2001. The U.S. entered 2001 with the fed funds rate at 6.5 percent. Amid signs of the weakening economy, the U.S. Fed embarked upon the now infamous rate-cut cycle that ultimately took the rates to 1 percent in mid-2003. During 2001 alone, however, the Fed cut rates from 6.5 percent to end the year at 1.75 percent.

“They continued on a fairly aggressive route, which suggested everyone was thinking ‘they are on it, they will give us a nice soft landing,’” Pressler says. “The thesis statement is that they did act and the recession only lasted eight months.”

The 2001 U.S. recession officially began in March 2001, but ended by November 2001. The Fed’s quick actions in 2001 compares to market perceptions that Japan’s response was almost passive during its five-year long foray toward a .50 percent rate.

At the time, the Fed’s move toward a 1 percent fed funds rate was heralded as a great success. Hindsight views that differently. Perhaps it wasn’t the rate cutting cycle to be blamed, but the rate hiking cycle; perhaps the Fed simply waited too long to start raising rates again. The Fed tugged the fed funds rate down to the 1 percent level in June 2003 and left it there for a year. The Fed didn’t start hiking rates until June 2004.

“They were proactive in bringing rates down, but by being reactive about bringing rates back up, they allowed an asset bubble to build which we are paying for now,” Pressler says.

There are trending and non-trending chart patterns; trying to apply the incorrect chart pattern to the market will most likely lead to a poor trade entry. The goal is to use patterns that provide clearly defined levels for the current market condition.

Because the objective here is to capitalize on sideways markets, let’s examine which chart patterns are ideal for momentum entries.

A triangle is formed between converging support and resistance lines. A down-sloping resistance line indicates a declining level of profit taking, or more uncertainty about the value of the stock. An upward-sloping support line squeezes price into a corner. Once the support or resistance line is broken, pressure that has built up as a result of uncertainty is released and momentum is added to the price change in the direction of the breakout.

Ascending and descending triangles are specific types of triangle patterns. An ascending triangle has a horizontal resistance line and a descending triangle has a horizontal support line. An ascending triangle usually forms as a continuation of a bullish trend, while a descending triangle typically forms as a continuation of a bearish trend.

Double tops and double bottoms are reversal patterns that touch either the support or resistance lines twice before reversing the trend. Triple tops and triple bottoms are reversal patterns that touch either the support or resistance lines three times before reversing the trend. A triple top or bottom is a stronger indicator of trend change than a double top or bottom. For both types of patterns, look for a strong initial trend and a significant breakout to confirm the reversal.

Also referred to as a sideways channel, a rectangle is a pattern formed between horizontal support and resistance lines.

Currency traders are two-for-two so far in 2007 as the Barclay Currency Traders Index (CTI) in February enjoyed a positive return for the second straight month.

While the index lagged behind others at Barclays such s the Agricultural Traders and the Systematic Traders indices, it nonetheless was up 0.40 percent on the year through February.

The index, which measures currency-based managed money programs (either futures or spot forex), was up 0.05 percent in January.

The index has had only four years of negative returns since first being calculated in 1987, but two of those years were 2005 and 2006. In positive years, the index has never failed to return less than 2.4 percent, with a composite return of almost 550 percent since 1987.

The BTOP FX index (BFI), which measures the largest currency trading programs, is down 0.18 percent through February. The index stood at 1,006.08 on Feb. 28, less than two percent from the all-time high of 1,023.64 set in December 2005. The BFI was virtually unchanged in February, falling 0.41 points, or 0.04 percent.

The FRR relationship between the GBP and the EUR has been markedly different than that between the CHF and EUR. Once the mattress trade ended and the FRR differential remained above zero into mid-2004, the GBP/EUR rate fell as expected. After mid-2004, British monetary policy tightened relative to that of the Eurozone and the FRR differential fell into negative territory. However, the GBP/EUR rate remained in a trading range rather than strengthening. And while the FRR differential remained negative, it was far from static: It fell sharply into the start of 2006 and then rebounded rapidly thereafter, all without a material and noticeable effect on the GBP/EUR rate.

Just as the volatility of CHF forwards fell continuously after early 2003, the volatility of GBP forwards also has fallen since late 2000, interrupted only by a May 2002-May 2003 rebound. EUR holders appear convinced the trading range will persist, as if ordained by some semi-official policy.

Any discussion of the EUR’s long-term history has to factor in one non-economic reason for its weakness in 2000-2001: the sale of “legacy” currencies hidden from the various national tax collectors prior to the introduction of cash euros in 2002. This so-called “mattress trade” made the CHF/EUR unnaturally strong during those years.

The difference in two countries’ FRRs can be used to compare their monetary policies. A country whose FRR is greater than another’s has a looser monetary policy and, all else held equal, its currency should weaken.

All else seldom is held equal, however. The Swiss FRR has exceeded its Eurozone counterpart since late 2001, but it did not break its trend support (dashed line) until the March 2003 Swiss rate cut. The CHF/EUR then collapsed under the weight of looser Swiss monetary policy, and that weakness persisted through late 2006 even though the Swiss FRR is flattening relative to the Eurozone FRR. It will take a renewed tightening of Swiss monetary policy to change this.

Will this happen anytime soon? The message from the cross-rate options market is, “No.” The cost of buying options on the CHF has declined steadily for EUR holders since the 2003 rate cut — which implies EUR holders who have borrowed the CHF and swapped it into EUR have no fear the CHF will strengthen anytime soon. Of course, these same CHF borrowers are increasing the risk of the underinsured event — a sudden rise in the CHF — by creating a path of greatest anxiety in that direction.

The expected interest-rate differential between two currencies is an excellent starting point for examining a currency cross-rate. The key metric for a currency is the forward rate ratio (FRR) between six and nine months, which is the rate at which we can lock in borrowing for three months beginning six months from now.

The FRR today provides a tradable interest- rate expectation applicable to the decision whether to roll a three-month nondeliverable forward for another three months starting three months from now. The more an FRR exceeds 1.00, the steeper the yield curve is over that segment and, by extension, the looser that country’s monetary policy is.

While the Swiss long have enjoyed a reputation for fiscal probity, they have been as willing as anyone to engage in monetary stimulus in recent years. Comparing the FRRs for the euro (EUR), British pound (GBP), and Swiss franc (CHF) since the January 1999 advent of the euro reveals the Bank of England (BOE) and the European Central Bank (ECB) have kept their monetary policies tightly aligned. The most notable exception was in late 2005 and early 2006 when the ECB maintained a looser monetary policy than the BOE.

Not so for the Swiss National Bank (SNB). The reduction of their target LIBOR from 0.75 to 0.25 percent in March 2003 — three months before the Federal Reserve cut the federal funds rate to 1 percent — propelled their FRR higher and well over comparable levels in the UK and Eurozone. Their increase of the target LIBOR in June 2004 to 50 basis points matched the Federal Reserve’s move in timing and size, and it started a very rapid change in their FRR.

Common statistical measures, such as the average and median price moves in different conditions, offer basic outlines of a market’s tendencies, while frequency distribution analysis gives traders even more insight into a market’s likely behavior in different circumstances.

For example, if you know a currency pair has in the recent past traded below the previous close between 0.004 and 0.0014 and closed higher that day 70 percent of the time, you have a solid guideline upon which to base trading decisions.

Here, we present a summary of the data from these articles for easy comparison of the different pairs. The analysis will be divided into two sections because three of the majors trade with the U.S. dollar as the base currency and four do not.

Given the wider spreads and reducedliquidity of some exotic currencies, some strategists feel the longer-term time frame is a better choice than day trading in this arena. Dolan cautions those nterested in expanding into the exotics.

“For the retail guy, the risks probably outweigh the rewards,” he says. “If they do get into it, it has to be more of a strategic and longer-term play.

” Olsen agrees on the time frame outlook.

“While a euro/dollar trader might trade a two- to three-hour position, a yuan play could last two to five weeks,” he says. “Trades put on in emerging market currencies are different in nature, and tend to be on more of a long-term time frame.”