Morning Brief – The Paradox of Intervention

The Paradox of Intervention

The US Dollar is on the rise. Of the 22 EURUSD trading sessions in September, 15 saw the US Dollar gain ground on the Euro. Overall, last month, the aggregate price move was approximately 2% in the favour of the greenback versus the Euro. In itself, the changing valuation of the US Dollar over the month of September was nothing to write home about. However, it added force to the growing momentum of the Dollar, contributing to a year-to-date displacement in the EURUSD currency pair of close to 7%. The rising cost of US Dollars is forcing other global central banks, particularly within the Emerging Market currency space, to intervene in foreign exchange markets.

Currencies miles apart both in terms of geography and characteristic are feeling the pressure of the Dollar and are worried about the potential impacts upon the stability of their own economies and price levels. To name but some, the Swiss Franc, Indian Rupee, Turkish Lira, Thai Baht and Korean Won are all feeling the pressure of the relentless Dollar. In turn many of the central banks which are responsible for issuing these currencies are expected, although not all confirmed, to have sold FX reserves in order to stabilise the value of their currencies. In order to take action on foreign exchange in the face of a rising Dollar and weakening domestic currency, a central bank will approach a market participant and request (normally) to sell USD in favour of their domestic currency. Within the currency pair in question this would, considered independently, create downward pressure on the Dollar and add to the perceived value of the domestic currency. Given that almost all emerging market currencies populate the ‘Term’ position of a currency pair, the cross should consequently face upward pressure.

Whilst that may stabilise the individual cross, there can be a counterintuitive impact upon wider USD pairs, most notably the most liquid of currency crosses, EURUSD. As central banks almost always sell USD in order to intervene in the market for their own national currencies, the composition of the central banks’ currency holdings will shift. Declarations of international currency holdings published worldwide on a routine basis inform us that generally it is the Euro that is the second most hoarded reserve currency within central banks. In order to restore the reserve holdings to the desired composition of currencies, the central bank is likely to perform a secondary trade to sell Euros and buy USD.

This pattern has played out in the past and is rumoured to be taking place in today’s market. Because the Euro represents some 50% of most major indices measuring USD strength, this pattern can create exaggerated images of USD strength. The break of significant technical levels could also promote further EURUSD selling with many participants now calling for a year-end to EURUSD in the low-teens.

Discussion and Analysis by Charles Porter

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