CENTRAL banks have never been averse to interventionist strategies. But the approach has certainly fallen from favour – and in spectacular fashion – on a couple of occasions in recent memory.
Just over twenty years ago, the UK was desperate to stay within the European Exchange Rate Mechanism (ERM), a system that required each member country’s currency to be kept within a certain trading range. Struggling with an overleveraged housing market and a lacklustre domestic economy, sterling wasn’t proving to be a terribly popular buy with anyone. Steadily, the Bank of England started to hike up interest rates in a desperate attempt to make the pound a better proposition. But George Soros famously kept adding trades to the other side of the equation, shorting the currency. Interest rates topped out at 15 per cent before time was called. The UK left the ERM, the country’s recession was prolonged, and the currency collapsed. Soros made an estimated $1bn (£617m) from the venture.
We’ve also seen repeated – broadly unsuccessful – interventions by the Bank of Japan over the years. Short-term interventions have been sniffed out by the market all too quickly. While the Bank of Japan may have helped the country’s lucrative export market from time to time – perhaps catching a few currency traders off guard along the way – such actions have roundly failed to deliver any meaningful longevity.
A slightly less dramatic scene has been played out with the Swiss franc. The currency was proving incredibly popular, as investors looked to find safe havens – especially for their euro holdings. Even with interest rates at rock bottom levels, investors were more than happy to buy into the infallible Swiss franc, and the currency fell from CHF1.60 against the euro in September 2008 to under CHF1.10 by July 2011. The Swiss franc’s relentless march upwards in value was having a crippling effect on Switzerland’s economy, and the Swiss National Bank declared that it would start buying foreign currency in unlimited quantities to weaken its own currency. This has been a hugely successful move and the Swiss franc has seen little appreciation over the last twelve months, trading in a relatively tight channel around the target of CHF1.20.
Perhaps the critical difference here is that the Swiss National Bank had the foresight – and the firepower – to realise it had to make this an open-ended proposition, so as to not enter into some kind of wealth transfer agreement from itself to high end financiers. We’ve since seen this played out in the Fed’s unlimited support programme, and also in the European Central Bank’s unlimited bond-buying scheme, which is designed to stabilise the euro.
Will this act as a turning point in central bank policy at the highest level? Against the failed examples we’ve seen above, it’s difficult to argue otherwise. Unless a bank’s policy is open-ended, how can the relevant central bank not end up making interim moves that will simply be picked off by those who understand this principle in the market? It does, however, mean that you’re now seeing an ever-increasing risk of big shifts occurring on currency pairs in a very short space of time. Within minutes of an announcement – or indeed even just the assumption in the market that some degree of intervention will take place – you can expect the news to be fully priced in.
Understanding the significance this can have for any trading plan is nothing short of imperative. If ever there was a time to make sure you protect yourself with a coherent risk management strategy, that time has to be now.
25 September 2012 1:13am
by David Morris