Long Swings in Exchange Rates

Let's now consider the hypothesis

that there are long swings
and exchange rates,

and you can think of this
as one possible theory

of currency movements

which you can contrast
with other approaches

such as the random-walk hypothesis.

Here's a history of the exchange rate:
the US dollar against the German mark.

So you can see there might appear
to be some long swings here.

So if you look at the late 1970s,
the dollar is pretty consistently falling.

Then there's a turning point in 1980,

and there's a period of about five years
where the dollar is rising quite strongly.

And then, perhaps, the bubble bursts.

In 1985, the dollar is
falling pretty suddenly.

And then there's a longer period
of a slower fall in the dollar;

think of that as another swing.

And then we have
this other turning point in 1995

where, after which,
the dollar against the German mark

seems to be rising again.

So in these data, it appears we see

a certain amount of momentum
in exchange rates

punctuated by periodic changes
in the direction of that momentum.

Note, of course,
that this may be in conflict

with an efficient-markets hypothesis.

If there's momentum and exchange rates,

it would seem that perhaps traders can
take advantage of this momentum

by trading against where they know
the exchange rate to be going.

This has been for a long time a puzzle
in the theory of international currencies.

As you can see in that graph of data,

the long swings hypothesis may be
combined with the view

that there is periodic regime-switching.

So, instead of the dollar going up
for a number of years,

the dollar may be going down
for a number of years.

But, of course, once you take
regime-switching into account,

the notion of momentum is
no longer so secure.

If you're trading on the basis
of expecting momentum,

well, it could be the case
that regime-switching

will turn the market against you.

The long-swings hypothesis
is taken seriously,

but as a hypothesis,
not as an established truth.

One point is simply that
the long-swings view

seemed to hold better in the 1980s
than it has held up since then.

Another problem with the hypothesis
is, again, if you look at this picture

of the exchange rate as a whole,

yes, it may be consistent
with long-swings view,

but it's also consistent
with a lot of other processes

which may be determining
the movement of exchange rates.

For instance, if the exchange rate
is a random walk,

it may also be the case that
you end up with a picture

which looks exactly like this.

So the tests we apply to the data,

when it comes to
the long-swings hypothesis,

we are, at best, getting
a do-not-reject result

and that's quite different from
an accept-the-hypothesis result.

To read more on
the long-swings hypothesis,

I would recommend these pieces here
which are available online,

and see also a number of related videos
contained in this course listed here.