It seems that every country's central bank these days is involved in some sort of capital control over their currency. Set aside from standard monetary and fiscal strategies, these policies are used to keep domestic denominations under control while keeping a country's growth stable. One of the most frequented strategies used by policy makers is direct market intervention. Japan's central bank has used the strategy on more than one occasion. By printing Japanese yen to sell, and buying back U.S. dollars, the Bank of Japan is controlling the value of its exchange rate against the American currency. (To learn more, see The U.S. Dollar And The Yen: An Interesting Partnership.)
TUTORIAL: The Forex Market
But that's not the only method that is being used, and the Bank of Japan is certainly not the only one intervening in the FX market. So let's take a look at some other capital control strategies that are being used by global central banks and how to take advantage of such an opportunity.
South Korea, with an export economy similar to Japan's, is a country that has also been known to intervene in the foreign exchange markets directly in order to control the rise and fall of its currency, the South Korean won (KRW). But things have changed, and South Korea's central bank is looking for additional means of control. An alternative to applying direct intervention in the markets, government officials and the Bank of Korea are beginning to audit banks and larger institutions handling currency market transactions.
Aimed at curbing speculation, the regulations tighten requirements on the country's banks trading in large currency derivatives, potentially punishing those that are unprofessionally or improperly transacting in the market.
Aiding in the reduction of currency speculation, the strategy increases government scrutiny over market positioning and would support higher requirements on currency positions for foreign currency speculators. All in all, the measure looks to gradually reduce interest in the South Korean won as it becomes more costly to trade currency in the country.
Another way to curb interest and speculation in a country's currency is through higher foreign investment taxes.
Brazil's Tax Change
The Brazilian government implemented measures in order to curb its own currency's speculation – aside from directly selling Brazilian reals and buying U.S. dollars. One such measure is to increase the foreign tax rate on fixed income (or bond) investments. The tax rate would affect foreign investors attempting to take advantage of a stronger BRL/USD exchange rate through large purchases of Brazilian bond investments. Originally at 2%, the tax rate increased to 6% as of October 2010.
Increasing the country's foreign tax rate is going to make transacting in Brazil more costly for speculators in banks and larger financial institutions abroad – supporting a disinterest in the Brazilian currency and decreasing the amount of "hot money" flowing into the Brazilian economy. (To learn more, see The New World Of Emerging Market Currencies.)
Using Central Bank Interventions to Your Advantage
Global central banks sometimes refer to strategies and tools that are already at their disposal. We all know that market speculation accelerates when central banks raise interest rates. During these times, investors look to capture any yield difference between their own currencies and higher yielding currencies. But, in times of massive market speculation, central banks may be forced to actually cut interest rates – hoping to deter any speculation on higher interest rates.
Central banks lowering interest rates are hoping to narrow the yield differential with other economies – making it less attractive for currency speculators attempting to take advantage of a wider yield difference. But, how can one take advantage of these opportunities?
It's simple. Although central banks apply capital controls on their domestic currencies, these policies tend to do little damage to the overall trend. In the short term, the announcement will temporarily shock markets. But, in the long run, the market ultimately reverts back to its original path. (Learn more in Interest Rates Matter For Forex Traders.)
An Example of How to Profit
Announcements of intervention offer great opportunities to initiate positions in the same direction as the recent trend. Let's take a look at the direct intervention efforts of the Bank of Japan on September 15, 2010.
In Figure 1, the USD/JPY exchange rate was moving lower since May 2010 on massive currency speculation. It was during this time that traders bought Japanese yen and sold U.S. dollars on the news that China was investing in Japanese bonds. The momentum helped the Japanese yen appreciate against the U.S. dollar from an exchange rate of about 95 per U.S. dollar to 84 in a matter of three months.
As a result of the yen's quick appreciation, the Bank of Japan decided to intervene for the first time in six years. At 84, the USD/JPY exchange rate was becoming too much for exporters to handle. The stronger yen was making Japanese products uncompetitive overseas. The announcement caused the USD/JPY currency pair to jump almost 300 pips overnight. In Figure 2, we can see the effects of intervention on our daily chart.
Now, this is where it gets interesting.
The intervention efforts by the Bank of Japan drove the currency to test projected resistance (red line) dating back to the currency's short-term top in May. Zooming in (Figure 3), we can see that the next two days produced two dojis just below support at 86.00 (red line). Dojis signify that momentum in the market following the intervention is exhausted – a sign of resistance failure.
Attempting to enter into the current bearish trend, we place a short entry at 85.50. This is just enough to confirm a breakdown in the short-term price action while remaining just below the 86.00 support. A corresponding stop is placed about 100-125 pips above our entry price - just enough to keep us in the position.
As expected, the overall bearish USD/JPY market trend continued with the pair dropping to support 80.25 before retracing a bit. This makes the USD/JPY short trade profitable by a maximum of 525 pips – maintaining a risk to reward ratio of almost five to one.
With increased speculation in the market, central banks will continue to apply capital controls in order to control their currency's exchange rates. These present great opportunities for retail investors and traders to seize entries into longer-term trends – as intervention scenarios rarely work for the policy makers. (For a step-by-step guide to trading forex, check out our Forex Walkthrough.)