Forex Investment and Currency Trading

So far, the spike in FX volatility and general USD strength has seen only one G10 central bank openly intervening to smooth currency depreciation – the RBA. However, after this month’s coordinated interest rate cuts, clear evidence of closer crosscountry cooperation on bank bail-outs and Monday’s G7 statement expressing “concern” on “excessive volatility on the exchange rate of the yen”, speculation continues to swirl on the prospect of coordinated central bank FX intervention.

Coordinated intervention has been a rare event in the last decade. Since the G3 central banks intervened to support a weakening USD in 1995, the only instance of concerted intervention was the September 2000 attempt to prop up EUR. This compares to the frequent coordinated central bank intervention that was the norm following the Plaza and Lourve accords of the mid-1980s and well into the early-1990s. But with policy paradigm shifts occurring on an almost daily basis, it is easy to understand why speculation of a return to the interventionist policies of the 1980s and 1990s is growing.

Most currencies close to fair value

Graph above shows current under/over-valuation vs USD, with the black lines representing the average deviation from PPP (purchasing power parity ) for each currency pair over the last 40 years. On this basis, there are few serious misalignments currently. Only CHF is outside its “normal” deviation from fair value band. JPY is overvalued and AUD and NZD undervalued, but not significantly so.

because the sharp moves in FX markets in recent weeks have, on the whole, been moves toward, rather than away from fair value, currency misalignment has diminished significantly to stand at a historically very low level.

Notably, concerted intervention has generally been associated with currencies in aggregate trading
far from fair value, the only exception being the Lourve accord in 1987, when intervention was specifically aimed at bringing an end to the USD-weakness induced by the Plaza Accord two years earlier. With the FX majors in aggregate trading closer to fair value than at any time in the last 40 years, concerted G7 intervention is seen as an distant prospect.

BoJ still a threat
Whilst concerted intervention may be a distant prospect, two factors in particular suggest not underestimating the risk that the BoJ unilaterally intercepts any further upward pressure on JPY. Firstly, numerous studies have shown that intervention is more likely to be effective when it is consistent with domestic monetary policy. And an imminent BoJ rate cut certainly add to that consistency. In fact, one of the principal reasons for the BoJ cutting rates may be to signal dissatisfaction with recent exchange rate movements. Secondly, and in stark contrast to recent experience, JPY is substantially stronger than it looks from USD/JPY alone. Although USD/JPY has
spent much of this year below the BoJ’s 2004 “line in the sand” of 105, against a broader basket of currencies the JPY level the BoJ last defended in March 2004 had never been retested – until mid-October when JPY strength against USD was compounded by strength against Asian EM currencies.
Despite the bounce in USD/JPY this week, against a broad basket of currencies, JPY remain 5% stronger than the March 2004 intervention level. As such, should remain well into the BoJ’s intervention danger zone.