In every big-bank currency
trading room in major financial centers, there is a direct line to the open
market trading desk of the central bank. When that line lights up, the whole
dealing room erupts. That line is reserved for open market intervention by the
central bank, and when it rings, it usually means only one thing: The central
bank is intervening in the market.
Intervention refers to central banks buying or selling currencies in
the open market to drive currency rates in a desired direction. Direct
intervention in the market is usually taken only as a last resort. It also may
be a stopgap measure to stabilize markets upset by extreme events, such as a
terrorist attack or rumors of a financial institution’s failure. When it’s not
necessitated by emergency circumstances, markets are generally aware of the
increasing risks of intervention.
Open market intervention is
usually preceded by several less-blunt forms of official intervention. The idea
from the governments’ point of view is to get as much bang for the buck as
possible before committing real money. Remember, Central banks have limited
firepower in relation to the overall market, so they have to pick their spots well.
Sometimes, the government's objective is simply to slow a market move to
restore financial market stability, and less drastic forms of intervention are
not yet necessary. Some of the more subtle forms of intervention are
- Verbal intervention or jawboning: These are efforts by finance ministry or central bank officials to publicly suggest that current market directions are undesirable. Basically, it amounts to trying to talk up or talk down a particular currency’s value. For example, if the Japanese MOF is intent on preventing further JPY strength to protect its export sector, but the USD/JPY rate keeps moving lower, senior MOF officials may indicate that “excessive exchange rate movements are undesirable.” This message signals currency traders to reduce their USD selling/JPY buying or risk the potential consequences. If the market ignores the warning, the MOF may take it up a notch and indicate that it is “closely monitoring exchange rates,” which is language typically used before actual open market intervention.
- Checking rates: This is the central bank’s open market desk ringing in on the direct line to major currency banks’ trading desks. The traders don’t know if it’s going to be a real intervention or not, but they still react instinctively based on previously indicated preferences. Even rumors of a central bank checking rates are enough to trigger a significant market reaction.
In terms of actual open market
intervention, there are several different forms it can take, all depending on
which and how many central banks are participating. The more the merrier;
better still, there’s strength in numbers.
- Unilateral intervention: This is intervention by a single central bank to buy or sell its own currency. Unilateral intervention is generally the least effective form of intervention, because the government perceived (usually correctly) to be acting alone and without the support of other major governments. Markets will typically revert to the earlier direction after the intervention has run its course to test the central bank’s resolve and to see if it’s intent on stopping the move or simply slowing it. The MOF/BOJ intervention in 2003 and 2004 was unilateral intervention.
- Joint intervention: This is when two central banks intervene together to shift the direction of their shared currency pair. For example, if the ECB and the SNB are concerned about Swiss-franc weakness versus the euro, they may decide to intervene jointly to sell EUR/CHF. This is a clear sign to markets that the two governments are prepared to work together to alter the direction of that pair’s exchange rate.
- Concerted intervention: This is when multiple central banks join together to intervene in the market simultaneously. This is the most powerful and effective type of intervention, because it suggests unity of purpose by multiple governments. Concerted intervention is not done lightly by major central banks and markets don’t take it lightly either. It’s the equivalent of a sledgehammer to the head. Concerted intervention frequently results in major long-term trend changes.
In term of the impact of
intervention, different governments are given different degrees of respect by
the market. Due to the frequency of past interventions and constant threats of
it, the Japanese tend to get the least respect. The BOE, the SNB, and the ECB
are treated with considerably more respect by markets, with the ECB being the
linchpin of credibility for the Eurozone. Finally, when the U.S. Treasury (via
the Fed) intervenes, it’s considered a major event, and the market usually
respects the intervention.
There is a difference between a
central bank intervening for its own "account and a central bank
intervening on behalf of another foreign central bank. For example, during the
MOF/BOJ intervention campaign in 2003 and 2004, there were several instances
where the U.S. Fed bought USD/JPY during the New York trading day. The first
reaction was that the U.S. Treasury was joining in and supporting the
intervention by the MOF/BOJ, and this amplified the effect of the intervention.
But the U.S. Treasury later denied that it had ordered the intervention. What
happened was that the BOJ asked the New York Fed to intervene on its behalf
during the New York trading session. Central banks have standing agreements to
act as each others’ representatives in their local markets. So even though the
New York Fed bought dollars, it bought them for the B0J.
Does intervention work? That is a
question that frequently comes up when central banks get involved. The simple
answer is an unequivocal “Yes, but ….” Intervention is most effective when it’s
backed by monetary policy moving in the same direction, such as expected higher
interest rates to support a weak currency or easier monetary policy to weaken a
strong one. Even then, interest rate changes are no guarantee that the
intervention will be successful.
In the short run, the
intervention may seem fruitless and counterproductive. This is especially-the
case with unilateral intervention. The market typically rejects the unilateral
intervention and reverts to pushing the market in the direction opposed by the
intervention. This situation can go on for weeks and months or in the MOF/BOJ’s
case in 2003 to 2004, years. When it’s a joint or concerted intervention, the
results are usually more immediate and successful.
