Currency Intervention: Will The Swiss Start A New Fashion?

In Part I, I took a look at what currency intervention meant, and why the Swiss felt the need to take action. Part II debates the merits of intervention and ponders on other likely suspects.

Does It Work?

This is a point hotly debated by people far cleverer than me, so I’ll stick to some observations.

The forex market is now so big that few central banks can hope to take it on and win. Coordinated action by a group of central banks stands a much better chance of success, not just because of the extra fire-power, but because of the impression of unity.

Intervention tends to work better when it comes as a surprise; witness the effect the Swiss National Bank’s announcement had on the currency. This is partly because it’s seen as a positive action and partly because it catches traders positioned the other way.

Success also depends on the underlying reason for the original currency move. For example, the original reason for a currency’s move might have been strong flows (opening or closing a carry trade). But momentum is then driven by speculators who pick up on the trend. Here, sharp and decisive action can be enough to burn speculators and bring an end to the trend.

If, on the other hand, the currency is being driven by an underlying problem with the country (see below) then speculators will keep up the attack until either the problem is tackled or it becomes too expensive to finance the trade.

George Soros Attacks Sterling

The UK features in forex folklore as a classic case of when intervention was futile. In 1992 the UK was attempting to shadow the German Deutschemark in something weird and stupid called the Exchange Rate Mechanism (ERM). Sterling was locked into a high rate and, despite recession in the UK, was compelled to defend this level. Germany insisted on a tight interest rate policy in the Fatherland (now that sounds familiar), which meant that rates in the UK had to go up, not down. Capitulation day was 16th September when the UK government took on George Soros and the speculator boys - and lost!

The trouble was that everyone knew that the UK was already in recession and it couldn’t survive with such a high currency and interest rates at 10%. So, the world kept selling Sterling. On Black Wednesday, as it became known, UK interest rates rose by 5%, but this only encouraged more selling of Sterling. That evening, after spending billions defending the currency, the UK threw in the towel, abandoned the ERM and started on a path of devaluation and lower interest rates. And George Soros became rather famous.

Will The Swiss Start A New Fashion?

Probably not, at least not in the currencies we’re most likely to trade. In the past few months there’s been plenty of intervention to protect the currencies of Russia, Mexico, Indonesia, Poland and Hungary.

What sets the Swiss action apart from these is that Switzerland was trying to weaken its currency; all the others had to defend theirs. Secondly, Switzerland was the first G-10 country to intervene in its currency since Japan in 2003-4. The thing is, if Switzerland can take their currency lower to make their goods more competitive then why can’t others?

For a while now China’s been playing ball, allowing the Renminbi to slowly appreciate against the Dollar. The trouble is, the Dollar has been soaring against most currencies (until last night), leaving China high and dry against its main trading partners. With exports 27% lower than a year ago, the Chinese might start to think that this stronger Renminbi policy is not such a good idea. The Swiss move does make it that bit harder to chastise the Chinese if they try to ‘help’ the Renminbi lower in the months to come.

Japan is the most likely major currency to see intervention; it does have a history. Japan’s economy is driven by exports, yet exports have fallen by 54% in the past six months, perhaps explaining why GDP in the fourth quarter of 2008 fell by an annualised 12%.

Japan came close to intervening to weaken its currency at the tail-end of last year when risk aversion trades saw traders selling the Euro and other high-yielders to buy the Yen. At the time when intervention was being mulled over the USD/JPY rate was around Y94, pretty much where it is now. But, crucially, the EUR/JPY rate is Y128.50, Y10 higher than November’s level.

Why Not Use Quantitative Easing Instead?

For a country that has got so much hopelessly wrong, the UK stumbled on a far cannier way of getting the Pound down. Once people had tired of various members of the MPC talking Sterling lower, the government embarked first on massive bailouts (we’re going bust so sell Sterling), and then on Quantitative Easing (we’re going to print money like the Weimar Republic).

The US certainly recognised the potential; witness the move in the Dollar following Wednesday night’s $1.15 trillion printing press.

Conclusion

With no inflation to worry about most countries would prefer a lower currency to help kick-start some export-led growth. But currencies aren’t like shares or bonds; they can’t collectively fall. For each currency that’s sold, another has to be bought.

At the moment the Euro is the strong silent type, with the ECB resolute in not succumbing to Quantitative Easing. That’s fine while the markets are in a purple patch, but what about the next downturn?

Nearly everything about the US, from its trade deficit to its multi-trillion giveaways, suggests the Dollar ought to fall. But traders are fickle creatures and they’ll soon again notice Europe’s decimated economies and the intransigence of the ECB. Then the Dollar could become the least worst currency again.

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