The Last Look…
Last week saw the 30th anniversary of one of the more remarkable days in my FX trading career, 16 September 1992 when Sterling was spectacularly dumped from the European Rate Mechanism (ERM), and it got me pondering, has the change in market structure also altered the likely outcomes of serious central bank intervention?
There is a perception that central bank intervention always used to work back in the day, however it was far from successful on so many occasions, not least when the Bank of Japan – which is currently making ominous noises about yen weakness – spent months unsuccessfully trying to reverse dollar strength in 1997/98. Other central banks also had mixed fortunes – even the mighty Bundesbank was bruised on occasion – and the departure of Sterling from the ERM is probably still a day anyone in authority at the time wants to forget.
Of course, it has to be noted there were times when intervention worked, not least the concerted efforts around the Plaza and Louvre Accords, but it was by no means a guarantee, especially if what the central bank was trying (as it could be argued is the case with the Bank of Japan currently) seemed to fly in the face of the economic reality.
Now though, I suspect matters could be different, and in those markets that have evolved to a largely electronic form, central bank intervention could have a much better chance of success.
Firstly, there are less risk holders in FX markets compared to the “heyday” of intervention in the 1980s and 1990s – the amount of risk out there may be higher, but it is concentrated in fewer hands, or, more likely, shunted around the system as a hot potato. Put simply, there is not an army of largely manual traders seeking to take advantage of a central bank-created anomaly in the market. This suggests that it would take less to get the exchange rate moving if the central bank timed and placed its trades carefully.
Secondly, once the trades do hit the market, so much of today’s price action is data-driven, therefore the market will react accordingly, and quickly. I understand that the EUR/CHF debacle was a different beast, but it showed how unlikely it is that machines will stand in the way of a major wave of selling or buying. Their job is to manage risk, and that so often means going with the flow.
Reinforcing this, is the fact that the buy side have become more reluctant to leave resting buy and sell orders with banks. Partly this is a factor of the chat room scandals, but more it is a reflection of how the buy side has tried to become more “professional” in how it acts in the FX market. If the market makers’ price engines don’t see resting interest, they are going to be whatever the electronic form of skittish is, and look to pass through risk.
Modern FX markets trade at most price points, but when the bids (or offers) are saturated, as they would be by large scale intervention, the ensuing gap is significant
The very fact that we have had flash events in FX markets without outside help indicates that a determined effort by a central bank could succeed more than it perhaps would have back in the day, when an intervention-induced move was often quickly reversed. In today’s market, where the data is everything, I would suggest, a la SNB, that the central bank would need to be careful they don’t leave too much blood on the street. That is, of course, one of the unspoken aims of intervention, but it should be limited.
There is a large caveat to all this, however, in that it is a market functioning, rather than economic fundamental issue. I still believe that intervention only works in the medium and long term if it is backed up by economic fundamentals, but I wonder now if, for example, the BoJ were to try to sell the dollar down, the initial impact would be significant, and perhaps larger than it was back in the last century? I use the word “initial” deliberately there, for it seems clear that at the moment, any intervention would fly in the face of the reality of a widening interest rate differential, but there would be a few nasty hours for the market before rational heads took advantage and bought the dollar dip.
It has been noted before that one difference with modern markets is that they trade at most price points, but when the bids (or offers) are saturated, as they would be by large scale intervention, the ensuing gap is significant, as witnessed by the flash events. This means that any central bank considering intervention in an electronic market may want to consider the amount it buys or sells, for my sense is that it may take less than before to get things moving in the “right” direction.
Of course, if a central bank is really determined to shift the exchange rate, there is one other option available – intervene when the market is at its thinnest. Perhaps if USD/JPY is above 145 on Boxing Day the BoJ could hit the market then? After all, one person’s market manipulation is another’s policy stance…