One of the most important roles of central banks is to implement monetary policies that will guarantee price stability and promote economic prosperity in the underlying country. The ability to use some tools such as ‘jawboning’ and other relevant actions is what defines intervention. Central bank interventions are essential because they help protect the value of a nation’s currency. This is done by buying or selling a nation’s currency in the forex market so that its value is raised or lowered against other foreign currencies.
In effect, central bank interventions are used to correct exchange rate misalignments or disorders. Such disorders can occur during economic crisis situations, such as the 2020 Great Lockdown and the 2008 Great Recession, or they can be abnormal short-term volatilities, such as a speculative attack on a currency. Exchange rate stability is very important in the economic growth and stability of any country. And this essentially means that central bank interventions are very important in dictating and sustaining the prosperity of the local economy by reducing volatility and promoting liquidity in the forex market.
For instance, if a country’s economy is reliant on exports, a strengthening local currency would hurt the competitiveness of its products on the international markets. This can prompt a central bank intervention that would aim to weaken the local currency. Likewise, a weakening currency can be damaging to a country that is heavily reliant on imports. It would mean that imports are expensive (thus threatening inflation). A central bank intervention, in this case, will seek to strengthen the local currency.
Central bank interventions happen in various forms. Here are four main types:
Also known as ‘Jawboning’, verbal intervention is the most basic and common intervention used by central banks. As the name suggests, jawboning involves ‘talking up’ or ‘talking down’ a currency instead of performing the actual action. Market participants are well aware of the power of central banks to perform monetary policy actions, and they will always scrutinise the speeches, testimonies or any other form of communication that come from the policymakers or governing officials. Jawboning is typically more of a type of guidance or announcement of intent to do something (such as reset interest rates) in the future, and the market will usually react as if that action has been taken now. Usually, central banks who are known to intervene frequently will see their jawboning efforts carry more weight in the forex market.
Generally used sparingly, operational intervention is when a central bank actually engages in the buying and selling of a nation’s currency in a bid to meet its monetary objectives. Central banks step in to the forex market when they desire a particular exchange rate level that cannot simply be achieved by jawboning. Operational intervention can cause significant price moves in the forex market because a central bank’s participation is geared towards meeting its objective and not making a profit.
Concerted intervention happens when multiple central banks join hands in an effort to influence the exchange rates of one or multiple currencies. This can only happen when multiple central banks have similar objectives towards a particular exchange rate. The relevant central banks can then proceed to apply jawboning or operational intervention options in a ‘concerted’ or coordinated manner so as to achieve their mutual objectives. Concerted intervention can impact the forex markets significantly and within a short time, depending on the number of central banks involved and the range of intervention measures they take.
Taking its name from the medical field, sterilised intervention involves taking actions to offset the potential negative impact of another operational intervention taken earlier. Central banks’ interventions are intended to have a positive impact on the forex market or generally help in attaining certain predetermined objectives. But these actions can also have unintended consequences, which must ultimately be addressed or ‘sterilised’ by the same central banks. In essence, sterilised interventions are conducted to ensure that none of the potential negative consequences of various interventions are experienced by or in the nation.
For instance, if a central bank is concerned about the strength of the nation’s currency, it can proceed to sell the currency in the forex market. By increasing the amount of the nation’s currency in circulation, the central bank will have achieved its objective of curbing the strength of the currency. However, with the increased circulation of the currency, there is the valid threat of inflation as well as other economic concerns. In light of this, the central bank can seek to sell short-term securities (bonds and treasuries) to absorb excess funds in circulation in order to curb the threats posed by the initial intervention.
How to Trade with Currency Interventions
Central bank interventions can cause extreme volatility in the forex markets. While this implies great and lucrative opportunities, it also means that there is considerable risk involved. The size and timing of intervention will determine the reaction of the market to the new information.
Big interventions can be expected from ‘big’ central banks such as the US Federal Reserve, Bank of England, Bank of China and the European Central Bank. Whereas the more unexpected an intervention, the more likely that its impact on exchange rates will be substantial. The most important aspect to consider when trading a central bank intervention is risk management. Because big movements are expected, measures should be taken to control market risks.
Here are some of the tips to follow when trading central bank interventions:
- Beware of major psychological price points. Traders should watch out for important levels (support and resistance) that have typically triggered a central bank intervention in the past.
- Trade in tandem with interventions. Central bank interventions are a big deal in the forex markets. It is advisable that traders only place orders that are in tandem with the currents of intervention.
- Trade contrarian trades with stop losses. If you must trade in contrary with intervention currents, it is advisable to trade with stop-loss orders because of the huge risk involved.
- Avoid placing orders around the announcements of interventions. Traders should avoid placing buy or sell orders in the market within a few minutes before/after or during the announcements of central bank interventions. This time period is characterised by massive volatility and price slippages, which may limit your chances of getting a good price on your order.
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