Imagine you’ve been watching the US dollar and Japanese yen for months. According to the fundamentals, USD/JPY is about to make a move.
Convinced the yen will skyrocket, you fill up your JPY bags on the forex markets.
That’s when the news hits: Japan doesn’t want that kind of volatility. The Bank of Japan stymies the meteoric rise of its currency with a foreign exchange intervention. The yen falls in value. You sell at a loss.
But wait! Now the yen is going back up — true to the fundamentals — but you already sold.
Maybe you should have learned about “foreign exchange interventions” before jumping the gun.
What Are Foreign Exchange Interventions?
National governments conduct foreign exchange interventions on the forex markets to stabilize their currencies against volatility. Most major governments — including the United States and Japan — do it, but not all of them.
Intervention is understandable. It works like ballast in the rough seas of the currency markets. When a storm begins to brew, governments open their coffers of reserve currencies to buffer the ups and downs (supposedly).
The US Federal Reserve says it intervenes to “counter disorderly market conditions,” but since the 1990s, interventions by the Fed have been few and far between.
“US FX intervention became much less frequent in the late 1990s. The United States intervened in the FX market on eight different days in 1995, but only twice from August 1995 through December 2006.”The Fed
Perhaps the drop in US intervention relates to this 1992 article, in which Gerald Anderson and Owen Humpage wrote:
“Although [foreign currency intervention] can sometimes be effective, we argue that, for the United States, it is unnecessary. This country — indeed, any nation with a well-developed money market — need not sell foreign exchange to reduce the supply of its currency.”
That being said, the Fed and other central banks could intervene at any time.
How Foreign Exchange Intervention Works
When “disorderly market conditions” threaten the stability of the US dollar, the Fed may choose to support the dollar against other currency prices. In this case, the Federal Reserve Bank of New York will purchase dollars and sell foreign currencies held in reserve. As of mid-April 2019, the Fed held about $42 billion in foreign currency for this purpose. If it wants to lower the value of the dollar against other currencies, it sells dollars and buys more foreign currency.
It’s similar in Japan. The Bank of Japan says that the Ministry of Finance will purchase US dollars against yen on the forex markets “in response to a sharp rise (appreciation) of the yen.” Conversely, it sells US dollars against the yen “in response to a sharp drop (depreciation) of the yen.”
What Do Seasoned Forex Traders Do When Central Banks Intervene?
Forex beginners don’t always interpret foreign exchange interventions correctly. For example, many make the mistake of believing that intervention works. On the other hand, seasoned forex traders know that — even if intervention works in the short-term — it doesn’t always produce a long-term effect. The underlying economic forces that caused the currency volatility may prevail despite the corrective measures of central banks.
Some forex traders habitually bet against central bank intervention. These traders view foreign exchange intervention as confirmation that the natural direction of the market is correct. As soon as they see the intervention, they’ll take a position against the central bank. It’s necessary to evaluate every intervention on a case-by-case basis.
The most famous example of “betting against a central bank” happened when George Soros took a massive short position against the British pound sterling. The Bank of England tried to intervene, but eventually it had to step aside. As the pound dropped, Soros made a cool $1 billion in profit.
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