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Fri Nov 25 09:52:25 PST 2005

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MARKING THE DEALER'S CARDS
Nov 24th 2005  

What economists can learn from currency traders

YOU can make a career as an exchange-rate economist without ever
crossing paths with a currency trader. The dealers who set the dollar's
price and the professors who theorise about it are separate breeds,
speaking different tongues and operating at quite different metabolic
rates. This is how Richard Lyons, an economist at the Haas School of
Business (part of the University of California, Berkeley), describes a
day spent with a friend of trading stock*[1].

If asked that question at the start of the year, most economists,
watching the steady deterioration of America's current-account balance,
would have told a dollar trader to sell. That would have been costly.
The greenback reached two-year highs against the euro and the pound
this month--before slipping back a bit after the president of the
European Central Bank indicated that higher euro-zone interest rates
were on the way.

The currency market routinely confounds economists. A classic 1983
study by Richard Meese and Kenneth Rogoff, then both at the Federal
Reserve, concluded that macroeconomic models could not explain a
currency's direction of travel, let alone how far it would go. One
would do just as well to assume that next month's exchange rate will be
the same as this month's. After another 20 years of interrogation, the
macroeconomic data has confessed little more of value. A new review of
the evidence&#8224;[2] finds that some models, in some periods, beat
tossing a coin. But not by very much.

TESTING THE TEA LEAVES
If traders can learn nothing from economists, can economists learn
anything from traders? No, is the customary answer. Economists
traditionally assume that everything worth knowing about a currency is
known by everyone; and that anything new is quickly embodied in the
price. They imagine the market governed by an auctioneer, who finds the
price that will square everybody's bids and offers before any actual
trading takes place. Economists study the auctioneer, not the traders.

After his visit to the trading desks, however, Mr Lyons decided that
dealers merited closer examination. He and Martin Evans, of Georgetown
University, are part of a wider effort to model the currency market
from "the trenches"&#8224;&#8224;[3]. We cannot understand how
currencies behave, they argue, unless we study the thinking and
behaviour of those who trade them. 

The mythical auctioneer is notably absent from the models they
construct. In his place stand the big currency dealers, who act as
marketmakers, willing to buy or sell any amount of currency at their
quoted prices. The marketmaker will take orders from a mix of
clients--from American multinationals repatriating profits, to Asian
central banks manipulating their currency--whose beliefs are as diverse
as their motives. 

These orders represent opinions, backed by money. As such, they convey
useful information about what clients believe and how strongly they
believe it. The marketmaker is privy to all of these opinions as they
accumulate on its order books, while its clients know only their own.
It is like a poker game in which only the dealer is allowed to see what
each player throws into the pot.

What can be learned from peering over the dealer's shoulder? Messrs
Lyons and Evans have access to six and a half years of data, ending in
June 1999, from Citibank, one of the largest dollar dealers. The
figures show the balance of orders flowing into the bank: on any given
day, customers may buy more dollars from Citibank than they have sold
to it, for example. This positive "order flow", as it is called, is
valuable evidence of buying pressure that is visible only to the dealer.

Any such pressure will eventually be reflected in a stronger currency.
What is surprising is how long it takes. Given that a trade is made
every few minutes, a quotation every few seconds, one would think that
any information in today's order flow would be swiftly incorporated
into the dealer's quotes and the dollar's price. Whatever forecasting
power the flow of orders possesses, it should be quickly exhausted.

It turns out, however, that the information in today's order flow will
still be percolating through the market weeks afterwards. It takes time
for a marketmaker to make sense of his orders, to distinguish signal
from noise, plot from happenstance. It takes more time still for that
insight to spread to the market as a whole, as dealers reveal what they
know through their quotes and trades with each other. This hiatus
creates an opportunity for forecasters. Messrs Lyons and Evans reckon
that Citibank's order flow can predict almost 16% of the dollar's
bobbing and weaving four weeks hence. That may not sound like a lot.
But the macroeconomists cannot even explain what is going on today, let
alone 16% of what will happen a month from now.

The two economists invoke Friedrich Hayek, who long ago pointed out
that the economy runs on "dispersed bits of incomplete and frequently
contradictory knowledge". These scattered insights, Hayek stressed, are
communicated to everyone through shifts in market prices. But with the
dollar, a big dealer's order books provide a sneak preview. If you can
look into those books, you can infer something useful about the dollar
next month. If not, then, like the rest of us, you can just flip a coin.

* "The Microstructure Approach to Exchange Rates". MIT Press, 2001.

&#8224; "Empirical Exchange Rate Models of the Nineties: Are Any Fit to
Survive?", by Y.-W. Cheung, M. Chinn and A. Garcia Pascual. JOURNAL OF
INTERNATIONAL MONEY AND FINANCE.

&#8224;&#8224; Many of their papers can be found at
www.georgetown.edu/faculty/evansm1[4].

-----
[1] http://www.economist.com/#footnote1
[2] http://www.economist.com/#footnote1
[3] http://www.economist.com/#footnote1

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