Studying monetary economics at the London School of Economics in the early 1980s led me to think that exchange rates were an equation to solve. After 20 years of operating in global markets, I have reached a different conclusion. It is true that the fundamentals have a significant bearing on the long-run trend of exchange rates. In particular, currencies prosper from low inflation, not inflationary growth. They also respond well to credible, certain policies not policymaking on the hoof. In short, it is best to think of currencies as an extension of the bond market, not the equity market?a mistake many novice traders make. Factors that drive bond markets up, drive currencies up.

That alone explains that while exchange rates follow broad cycles, the trend of the dollar versus the Swiss franc, euro and the yen and other low-inflation zones is to weakness, with new cycle high and lows being generally lower than earlier ones. The Swiss and European economies may not be as dynamic as the US, but inflation is generally lower. But these trends operate over periods that are longer than a Madoff scam. Most investors I know, claim to be long-term, fundamental and everything else that sounds respectable in polite company, yet they scurry out of a position if it sours over a few days. Investors generally think long-term, but act short-term. The problem is that forces that drive markets over the short-term are different than those that act over the long-term. To think the long run is merely made up of many short runs is a fallacy of composition.

Many investors view this departure from fundamentals as ?irrational?, but this irrationality is not fleeting. John Maynard Keynes, the economist and investor said, after losing his shirt trading the deutschemark, dollar and rupee, ?markets can remain irrational for longer than you or I can remain solvent?. One of the most powerful forces acting on currencies over the near-term is investors? shifting appetite for risk. Investors exhibit a cycle of risk appetite. Mostly risk appetite is high and when it is, high-yielding assets outperform others as investors discount the risks the yields provide compensation for. This is where ?carry trades? in foreign exchange and debt markets reign. But then some event occurs which causes a loss of risk appetite or risk aversion. Then position unwinding is king.

Currencies and risk appetite

My thinking about this was born of emerging market crises during the 1990s, when I was head of currency and commodity research at JP Morgan. As a crisis unfolded, the traders would call on the economics department to make sense of it all. The economists would walk down to the dealing floor and explain which countries had strong fundamentals and would survive the crisis unscathed, and which countries had weak fundamentals and would be ?brought down?. They would get it spectacularly wrong.

In peril, investors do not look for new ground; they look to retreat. They retrench from markets where they thought the fundamentals were good and as they are in risk-reducing mode they have no appetite to go and ?short? markets with bad fundamentals. Those countries in which the fundamentals appeared strongest before the crisis were those suffering the greatest capital outflows. When the Asian crisis hit in 1997-98, emerging markets suffered a major reversal of capital because prior to the crisis, with stories of Asian Tigers and the ?Washington Consensus?, international investors were heavily invested. When Argentina collapsed in 2002, the same macro economists, thinking they had learned their lesson, predicted a tsunami of contagion that would bring down both the good and the bad. But there was no contagion. Just before the Argentine crisis, the prevailing view, shaped by the near-memory of the Asian crisis, was that emerging markets were risky, low yielding places with high degrees of correlation. Few international investors were invested.

While I have learned to think in terms of the long and the short run in markets being somehow disconnected and driven by different factors, a curious dynamic occurs in markets where commentators look for those trends in fundamentals that fit the trend in market prices and proclaim that it is these new, bad, fundamentals that are driving markets. The academic economist Paul DeGrauwe described this approach as fundamentals following prices (rather than fundamentals following prices). It is an approach to markets that gives us all peace of mind that rationality prevails and the sky will not fall on our heads while we sleep, but it is an approach that fails Sir Karl Popper?s test of a rigourous scientific theory?one that can predict the future rather than the past.

Investors? shifting appetite for risk can be observed and measured. Those familiar with this notion will have come across the various incarnations of the Risk Appetite Index I developed in 1996 while at JP Morgan. Many financial institutions, in particular, Deutsche Bank, UBS and JP Morgan?all the majors that survived ?have versions of the Index today. A description of the original index, written with Dr Mohan Kumar, can be found in an IMF Working Paper (No 01/134). Since then, Miroslav Misina of Bank of Canada has improved on the Index calculation.

Dollar strength is temporary

This is a very roundabout route to the point that the dollar?s appreciation in the second half of 2008 had little to do with fundamentals, but a rational degree of retrenchment in a world of declining risk appetite. Because most investors were busy shorting the dollar due to poor US fundamentals prior to the crisis, retrenchment and position unwinding meant that investors had to buy back dollars. Moreover, the US dollar remains the world?s reserve currency and so some have had to buy dollars in order to be liquid in the world?s reserve currency. Once positions have been unwound, and it doesn?t take six months to do so, and once the liquidity crisis has stabilised, if only because liquidity is now about government guaranteed banks lending to other government guaranteed banks, the dollar will return to trading with the fundamentals.

What are these fundamentals? Unemployment and consumer confidence are economic variables that are useful proxies for the ability of the monetary authorities to pursue an anti-inflationary stance. Both are flashing red from a currency perspective, but then again they look weak elsewhere, especially Europe, and the US authorities are the most aggressive in trying to rescue the economy. But this aggression is about raising government debt and taking risks with currency stability. Inflation is not a threat today and nor is the level of government bond yields, but debt is spelled i-n-f-l-a-t-i-o-n and US debt levels are going through the roof.

While the Germans prepare a stimulus package of $75bn, the combined

American packages are close to US$1trn and the long line of special pleading is only just forming. The German economy is more than one third of that of the US so the combined US package is equivalent to the Germans preparing a package of $350bn or five times the amount being considered. The markets will begin to tire of the sheer amount of policy activism and discretion in the US and the absence of consideration of foreign holders of dollar instruments. Some currency traders think this attitude is good for the dollar, but they are not thinking like a bond investor and they are not worrying enough about policy certainty and credibility. There is a new and inspirational president about to take over the reins in the US and this could change the picture, but currently no one holding dollars will be feeling comfortable that the guardians of the world?s reserve currency are sufficiently concerned about preserving its value. Dollar strength is over and the euro and rupee will make a fresh assault on the $1.50 and Rs 40.00 levels before the quarter is out.

?The author is chairman of London-based Intelligence Capital, governor of the London School of Economics and emeritus professor of Gresham College in the UK