Tuesday, February 12, 2019

FX intervention - Analysis says central bank activity works

Many have held the view that central bank FX intervention is ineffective. It can be disruptive and have some temporary impact, but central banks cannot make currency markets do what they don't want to do. Research using public data, a limited sample and mainly focused on floating exchange rate regimes, shows, at best, mixed value for intervention. Nevertheless, intervention does create market frictions and an investor can take advantage of those central bank actions. 

The latest economic research based on extensive private central bank intervention data tells a different story and suggests that central bank intervention is effective at meeting bank goals. See "When Is Foreign Exchange Intervention Effective? Evidence form 33 Countries" American Economic Journal: Macroeconomics 2019 by M Fratzscher, O. Gloede, L Menkhoff, L Sarno, and T Stohr. 

When looking at the private information from central banks with a data set never before assembled, the evidence shows that central banks are very good at getting the policy goals they want. The authors find that central banks have a success rate of over 80 percent when using specific goal criteria. Intervention is effective at both smoothing exchange rates, and stabilizing exchange rates that are controlled by a band. The success of intervention in floating exchange rates, however, is lower and needs larger trading volume, public disclosure of the intervention, and supported by communication of goals. There is less success if central bank attempt to move rates against fundamentals or try to change the direction of exchange rates is response to an event.

For traders, there are some straightforward take-aways:

1. Read intervention based on the context of the currency regime, policy objectives, and communication.
2. Listen to what central banks tell you - They signal their actions. 
3. Don't fight with central banks especially in currencies that have bands.  
4. Central banks are good at controlling currency levels especially in EM and less liquid currencies in the short-run. 
5. Central banks are not as good at using intervention to stop fundamentals.
6. Central banks will smooth prices, create frictions, and can be exploited given the currency regime (flexible versus bands). 

Central banks have a stronger impact on currency rates than has generally been seen in research. Central bank actions against macro fundamentals will not be effective, but the path to central bank currency control failure can be long and bumpy. In the meantime, use intervention as a means to exploit trends and short-term mean reversion. 

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