While these flow and sentiment models vary, both in terms of the time span they focus on and the kind of information they look at, the basic premise behind them is the same — exchange rates are determined by the supply and demand for currencies, in other words by “order flow”. Over time, economic fundamentals will dictate the order flow and therefore the exchange rate itself. However, currency market practitioners do not necessarily have that long to wait. Therefore, it is necessary to study order flow separately and independently from the fundamentals, and moreover it is necessary to study the drivers of that order flow.
The key distinction between a speculative and a non-speculative capital flow, keeping to the definition that we are using for speculation — which is that speculation involves the buying and selling of currencies with no underlying attached asset — is the exchange rate itself. For a speculator, the exchange rate is the primary incentive for investing, using this definition. However, for an asset manager, the exchange rate is not the primary consideration, which is the total return available in the local markets. As the barriers to capital have broken down and as currencies have been de-pegged and allowed to float freely, so both speculative and non-speculative capital flows have grown exponentially. There remains a dynamic tension between the two, allowing one or other to be more important in terms of total flows at any one time.
Generalizing somewhat, one can say that speculative flows dominate short-term exchange rate moves, while non-speculative flows that are attracted by long-term fundamental shifts in the economy dominate long-term exchange rate moves. This is a nice, cosy definition of the dynamics affecting exchange rates, however there is a problem. Financial bubbles are seen as essentially speculative creations, yet they are generated not by short-term exchange rate or asset market moves but by long-term and increasingly self-perpetuating shifts. The essential lesson behind this is that it is in fact exceptionally difficult to differentiate the speculative from the non-speculative. It is easier to focus on the incentive rather than the result. The primary incentive behind speculative flow, using our definition of speculation, is that it is mainly driven by the exchange rate not the interest rate. If it were the latter, neither the Japanese yen nor the Swiss franc would ever have risen. Yet, since the 1971–1973 break-up of the Bretton Woods exchange rate system, both have trended higher against the US dollar (and most other currencies). Expectations about the exchange rate are the primary motive and incentive behind speculative capital flow. This is a lesson that many economists have yet to learn, largely because many of their theoretical ideas of how exchange rates should behave do not work in practice.Perception and outcome are intrinsically linked in the currency markets; they are both cause and effect. This creates a self-fulfilling and self-reinforcing phenomenon, which becomes more speculative the longer it lasts, until it becomes unsustainable and the bubble bursts.
Free floating exchange rates tend to trade and trend in cycles, and flows are both cause and effect in this regard. Such currency cycles are not of necessity timed with the economic cycle. It depends why they start. After the bubble bursts, there is usually a period of consolidation and reversal; the longer the initial trend or cycle, the longer in turn the reversal. Thus, we saw a weakening trend for the US dollar in the 1970s, followed by a strengthening in the early 1980s, followed by renewed weakening from 1985 to 1987, which again was reversed towards the end of that decade. The 1990s saw a similar pattern, with the US dollar weak from 1991 to 1995, which was followed by a broad strengthening trend that has lasted from 1995 through 2001. This suggests that at some point the US dollar strength cycle will end and be reversed. Trying to determine the top is for the most part impossible. It is more important to be able to understand the cyclical nature of the currency markets and to be able to plan accordingly ahead of that cycle ending. To prove the point, towards the end of 2001 the US dollar was continuing to strengthen despite the fact that the Fed funds’ target interest rate was at 1.75%, while the European Central Bank’s repo rate was at 3.25%. Nominal interest rates are not the primary incentive for speculative capital flow, never have been and never will be. The exchange rate itself is the incentive. This is an important realization.