Chapter 25
Fundamental Trading Strategy: Intervention

Intervention by central banks is one of the most important short- and long-term fundamentally driven market movers for the currency market. For short-term traders, intervention can lead to sharp intraday movements on the scale of 150–250 pips in a matter of minutes. For longer-term traders, intervention can signal a significant change in trend because it suggests that the central bank is shifting or solidifying its stance and sending a message to the market that they are backing certain directional move in their currency. There are basically two types of intervention: sterilized and unsterilized. Sterilized intervention requires offsetting intervention with the buying or selling of government bonds while unsterilized intervention involves no changes to the monetary base to offset intervention. Many argue that unsterilized intervention has a more lasting effect on the currency than sterilized intervention.

Taking a look at some of the following case studies, it is apparent that interventions in general are important to watch and can have large impacts on a currency pair's price action. Although the actual timing of an intervention tends to be a surprise, quite often the market will begin talking about the need for intervention days or weeks before the actual intervention occurs. The direction of an intervention is almost always known in advance because the central bank will typically come across the newswires complaining about too much strength or weakness in their currency. These warnings give traders a window of opportunity to participate in what could be significant profit potentials or to stay out of the markets. The only thing to watch out for, which you will see in our case study is that the sharp intervention based rallies or selloffs can quickly be reversed as speculators come into the market to “fade the central bank.” Whether or not the market fades, the central bank depends on the frequency of central bank intervention, the success rate, the magnitude of the intervention, the timing of the intervention, and whether fundamentals support intervention. Intervention is much more prevalent in emerging market currencies than in the G7 currencies because these countries need to prevent their local currencies from appreciating too significantly such that it would hinder economic recovery and reduce the competitiveness of the country's exports. Nonetheless, G7 interventions will happen and its rarity is exactly what makes them significant.

Japan

In the past two decades, the central bank most willing to engage intervention is the Bank of Japan. As an export dependent country, a strong yen poses a major risk to the export sector. While the Bank of Japan conducts the intervention, the decision is made by the Ministry of Finance. The most recent case of intervention by the Japanese government was in 2011. The BoJ largely stayed out of the market between 2012 and 2015 because Abenomics helped to drive a recovery in the economy. On October 31, 2011, USDJPY hit a record low, which means that the Japanese yen hit a record high. Frustrated with the currency's strength after the 2011 earthquake and tsunami, the Japanese government came into the forex market aggressively to sell the yen and buy the dollar. On that day, their intervention efforts drove USDJPY from a low of 75.575 to a high of 79.50, almost 400 pips. As shown in Figure 25.1, 90% of this move happened in the first 35 minutes.

Figure 25.1 USDJPY Chart

The Bank of Japan also bought USDJPY in August 2011, but one of their biggest intervention programs was in March 2011, when central banks around the world joined the BoJ to sell the yen as a sign of solidarity after an earthquake and tsunami drove the currency to a record high. On that day, intervention only drove USDJPY from 79.18 to 82, but a few weeks later it hit a high of 85.50, as shown in Figure 25.2.

Figure 25.2 USDJPY Chart BoJ Intervention

The Bank of Japan also intervened in September 2015 and as shown in Figure 25.3, a daily chart, USDJPY jumped nearly 300 pips that day. Typically, USDJPY will move 75 to 150 pips on an average day, so a 300-pip move that happens in minutes is significant. In all but one of these four cases, the intervention move was reversed almost immediately. The only reason why USDJPY extended its rally in March 2011 was because the intervention was coordinated with other central banks, making it more powerful.

Figure 25.3 USDJPY Chart BoJ Intervention

While the Japanese government has been quieter in recent years, they were very active in the early twenty-first century. The frequency and strength of BoJ intervention during this period created an invisible floor under USDJPY. Although there has been no more mention of this floor in recent years, the BoJ/MoF instilled enough fear that intervention is always a worry. This fear is well justified because in the event of BoJ intervention, the average 100-pip daily range can easily triple.

Japanese intervention can be traded one of two ways—ride the move on the day of intervention or fade it in the days that follow. The key is not to be greedy, because the Japanese government can always step in again. Committing to take a solid 100-pip profit (of a 150–200 pip move) or using a very short-term intraday trailing stop of 15–20 pips, for example, can be helpful.

Switzerland

The Swiss National Bank's 1.20 EURCHF floor is another form of intervention. Faced with a high level of uncertainty in the financial markets, an overvalued currency, and deflation risks in 2011, the SNB introduced a minimum exchange rate of CHF 1.20 per euro. At the time, they pledged to sell francs in an unlimited quantity to maintain the peg. The goal was to stabilize the Swiss economy by capping the gain in the franc. As shown in Figure 25.4, the peg was very effective in keeping EURCHF above 1.20 between late 2012 and 2014. However, in January 2015, the prospect of quantitative easing from the European Central Bank pushed the SNB to abandon their peg, and their surprise announcement caused a 30% one-day decline in EURCHF. Many foreign exchange brokers were unprepared for the move and experienced massive losses as a result.

Figure 25.4 EURCHF 1.20 Peg

Other central banks have also intervened in their currency in the past decade including the Reserve Bank of New Zealand. Unfortunately, for the RBNZ, most of their efforts failed with the currency rising after each round of intervention. For forex traders, this creates an opportunity in that it provides the case for buying the currency after intervention.

Eurozone

The European Central Bank on the other hand is fairly quiet. They have only intervened a few times before, the most recent of which was in 2000. The ECB came into the market to buy euros when the single currency dropped from 90 cents to 84 cents. In January 1999, when the euro was first launched it was valued at 1.17 against the U.S. dollar. Due to the sharp slide, the European Central Bank (ECB) convinced the United States, Japan, the United Kingdom, and Canada to join them in coordinated intervention to prop up the euro for the first time ever. The Eurozone felt concerned that the market was lacking confidence in their new currency but also feared that the slide in their currency was increasing the cost of the region's oil imports. With energy prices hitting 10-year highs at the time, Europe's heavy dependence on oil imports necessitated a stronger currency. The U.S. agreed to intervention because buying euros and selling dollars would help to boost the value of European imports and aid in the funding of an already growing U.S. trade deficit. Tokyo joined in the intervention because they were becoming concerned that the weaker euro was posing a threat to their own exports. Although the ECB did not release details on the magnitude of their intervention, the Federal Reserve reported having purchased 1.5 billion euros against the dollar on behalf of the ECB. Even though the actual intervention itself caught the market by surprise, the ECB gave good warning to the market with numerous bouts of verbal support from ECB and EU officials. For trading purposes, this would have given traders an opportunity to buy euros in anticipation of intervention or to avoid shorting the EURUSD.

Figure 25.5 shows the price action of the EURUSD on the day of intervention. Unfortunately, there is no minute data available dating back to September 2000, but from the daily chart, we can see that on the day that the ECB intervened in the euro (September 22, 2000), with the help of its trade partners, the EURUSD had a high-low range of over 400 pips.

Figure 25.5 EURUSD Intervention

Even though intervention does not happen often, it is a very important fundamental trading strategy because each time it occurs, price movements are substantial.

For traders, intervention has three major implications for trading:

1. Bet on intervention: Heed the warnings from central bank officials and use it as a signal for possible intervention—the invisible floor created by the Japanese government gave USDJPY bulls plenty of opportunity to pick short-term bottoms.
2. Avoid betting against intervention: Betting against intervention can be dangerous because one bout of intervention by a central bank could easily trigger a sharp 100–150 plus pip move in the currency pair, taking out stop orders and exacerbating the move.
3. Use stops when intervention is a risk: With the 24-hour nature of the market, intervention can occur at any time of the day. Although stops should always be entered into the trading platform immediately after the entry order is triggered, having stops in place are even more important when intervention is a major risk.