Why Forex Market Intervention Usually Does Not Work
Updated: April 05, 2013 at 8:55 AM
Many experienced forex traders have observed over the span of their careers in the forex market that intervention by central banks to support or weaken their currency is generally not effective in reversing market trends in the long run. This can be exploited by seasoned traders with a lot of muscles. In this article we'll explain why.
Certainly bouts of official currency intervention can create notable short term corrective bounces or even spikes that run counter trend.
Nevertheless, the underlying trend that initially prompted the intervention usually tends to subsequently reestablish itself once the central bank is eventually forced to move aside as its efforts are ultimately dwarfed by the prevailing market sentiment.
Intervention Might Smooth a Trend but Rarely Reverses One
Basically, when central banks and governments intervene in the capital markets, they are up against the forces of the free market and must abide by the rules of supply and demand, much like all forex traders.
The act of intervention in favor of one currency against another simply postpones the inevitable changes in valuation required by market forces.
This pressure most often ends with the currency that is the subject of the intervention activity resuming its previous trend after a brief corrective respite initiated by the official intervention in the market.
Professional Traders Position Themselves Against the Central Banks
Professional forex traders seasoned in calling the currency markets even use central bank intervention as an indication that the overall direction of the currency is correct.
Once such intervention is observed, they will often use that as a signal to wait to pick a spot to get into the market and trade against the central bank that is performing the intervention.
The Pound Sterling's Devaluation and Ultimate Exit From the ERM
As a well known example of such a trading strategy, take famous currency trader and Quantum hedge fund founder George Soros.
Soros took advantage of the Bank of England's ultimately futile attempts to protect the Pound Sterling's position in the European Exchange Rate Mechanism or ERM in the early 1990's.
Soros and his Quantum Fund subsequently profited substantially after Sterling devalued and the central bank was eventually forced to cease its intervention activities.
Even the BOE's move to raise U.K. interest rates sharply higher could not turn the tide and defend the Pound from intense speculative pressure led by Soros and his large fund.
This selling pressure eventually resulted in the Pound leaving the ERM, as well as considerable losses for the Bank of England to digest. You can read more on this story here.
Japanese Official Intervention to Weaken Yen Also Unsuccessful so far
Another notable example of the lack of success of central bank intervention policy is the exceptionally poor track record of the Bank of Japan or BOJ when it comes to weakening the strength of the Japanese Yen seen during the last three decades.
In essence, each time the Bank of Japan has stepped into the currency market to sell its currency, the market in USDJPY has temporarily bounced back up, only to see further selling pressure eventually take the rate lower.
Even concerted central bank intervention involving the BOJ in addition to the U.S. Federal Reserve Bank and the European Central Bank have ultimately proven no match for the huge forex market's push to strengthen the Japanese Yen as can be seen in th examples below.
Historically, the Bank of Japan last intervened in the forex market on March 16th of 2004 when USDJPY was trading at 109.00 by selling 14.8 trillion Yen in Q1 of 2004. The BOJ had previously sold 20.4 trillion Yen during 2003.
In spite of this persistent and significant forex market intervention, USDJPY continued to fall during 2004, eventually ending the year lower at 102.63.
Prior to this, the BOJ was seen actively intervening in the forex market during the period from September 17th, 2001 up until June 28th, 2002. Even the U.S. Federal Reserve Bank stepped in to lend a hand to help bring down the strong Yen on September 27th of 2001.
At the time of these interventions, the level of USDJPY was near 123.00. The central bank intervention persisted until June of 2002, without subsequent significant results in weakening the Yen.
Furthermore, the BOJ was seen selling Yen eighteen times during the period from January, 1999 until April, 2000. Even when aided by the Fed and the European Central Bank on one occasion, the BOJ failed to stem the market's strengthening of the Yen that eventually traded to the 102 level in April of 2000.
Even further back in 1995, the Japanese Yen traded to its major high as USDJPY fell to 79.75 on April 1st of that year despite repeated central bank intervention by both the BOJ and the U.S. Fed.
However, rumored current Japanese Intervention Funds are Impressive
An important factor that can contribute to the BOJ's success going forward is the market estimates that the Japanese central bank has around $10 trillion worth of Yen stored up and waiting to sell as necessary to help weaken the Yen.
Japanese finance officials have also verbally assisted the BOJ in its intervention activities by drawing an invisible psychological support line at the 82.00 level for USD/JPY.
This somewhat arbitrary point comes in just below the rate's most recent 15 year low at the 82.87 level seen in mid September 2010 immediately before the initial bout of BOJ intervention took place.
The central bank's subsequent purchase of roughly $10 billion versus the Yen in the forex market, according to market estimates, then helped bring the rate sharply back up to the 85.92 level.
Intervention Fails to Reverse Strong Trend Favoring the Yen - Yet
Although this most recent intervention driven rally in USD/JPY still failed to reverse the pair's prevailing downtrend, it did bring the rate significantly higher to test a key downward sloping trend line that currently indicates significant resistance to rallies in USD/JPY.
If this down trend line ultimately breaks, a more sustained rally in the rate should then ensue that will most likely vindicate the BOJ's current Yen sales to help prop up USD/JPY.
Nevertheless, if that key line continues to hold, the BOJ will probably again need to show its face in the forex market to help keep the Yen from strengthening further.
Global Investors Seeking Security in Both the Yen and Swiss Franc
The recent strength seen in the Japanese Yen has largely arisen from risk averse asset flows into Japanese investment markets.
Basically, because of persistent investor wariness about the U.S. Dollar's fortunes - due in part to the weak U.S. economy, as well as the record U.S. budget and trade deficits - global investors seeking security have primarily shifted assets out of U.S. Dollars and into the Japanese Yen, as well as the Swiss Franc.
Both of these currencies are now often perceived as relative safe havens in the increasingly risky global investment environment that has resulted from persistently weak economy in the United States that was led by the housing market downturn.
In addition, largely as a result of the recent sovereign debt crisis in Europe that was sparked off by Greece experiencing debt problems in early 2010, many investors have also been exiting Euro denominated assets. The overall effect of this capital flow out of the Euro is that Yen and Swiss Franc based assets have tended to be the most common beneficiaries.
Such a flight to quality among international investors has resulted in considerable flows into both of these safe haven currencies since 2008.
The key question regarding the effectiveness of the recent BOJ intervention efforts therefore involves whether these massive capital flows into the Yen will be sustained in the face of clear disapproval of Yen strength on the part of the Bank of Japan.
If these flows do indeed persist, then the BOJ will most likely eventually have to step aside since even its apparently impressive efforts cannot turn the huge tide of international investor sentiment that currently dominates the forex market.
All of this indicates that central banks have very little success with their interventions to counter a strong market trend based on fundamentals.
Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.
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