By Kathleen Brooks: Research Director UK, FOREX.com
The last couple of weeks have been a roller coaster ride for investors in the foreign exchange market. Some of this volatility was fueled by fears about the European debt crisis and growth prospects for the debt-ridden western world, but a new risk factor has altered market dynamics: intervention risk.
Traditionally during periods of market turmoil FX investors have turned to the Swiss franc and the Japanese yen. It is hard-wired in traders that the Swissie and the yen are the asset classes of choice when risk is sold due to their relative political stability and high proportion of debt held domestically.
However, not any more. After hitting record highs versus the euro and the dollar, the Swiss National Bank (the SNB) said enough-was-enough and started to directly intervene in the markets from August 3, 2011.
Swiss Franc Movement
The SNB took the market by surprise and lowered interest rates to zero try and dissuade people from buying its currency. The logic was that if a currency doesn't yield anything investors don't earn a return and so won't want to buy the currency. But old habits die hard. At the peak of last week's turmoil when the markets were fearful for the European banking sector and as French bond spreads with Germany reached multi-year highs, the Swiss franc was a mere 70 pips away from parity against the euro.
After failing at its first attempt the SNB isn't taking any chances and is currently boosting its weaponry to try and weaken the franc. It is reported to be looking at a potential peg to the euro, negative interest rates and even targeting a floor in EURCHF and USDCHF that would formalize direct intervention in the currency markets once the Swissie reached a certain level.
Rather than rush into the Swiss franc when the going gets tough, investors now need to take a step back and consider if they want to fight the SNB. After near capitulation there has been a massive rebound in EURCHF, which has surged by more than 10 big figures as the franc sagged. The SNB is serious and will do all it takes to dampen buying pressure on its currency.
Japan Follows Switzerland
The Japanese followed suit quickly after the SNB announced its action. Investors crowd into the yen during periods of turmoil in the markets, particularly into dollar-yen, which has also reached record lows. But the Bank of Japan, having intervened in the past and had its fingers burnt, did not use the heavy tactics of the SNB and the yen has managed to keep hold of most its value. The Japanese authorities may have to take more action as exporters are already complaining about yen strength and some analysts think it will hit third quarter growth figures.
What It Means for the Markets
This has major market implications as central banks can intervene in the markets or lower interest rates to reduce upward pressure on their currencies without any notice as the SNB and BOJ have reminded us. While the outcome of central bank action can be different: it can have a major market impact like the SNB or end up more of a damp squib like the BOJ, it has one common feature – often central banks don't give warning.
Investors now have to try and price in the prospect of central bank risk. As we mentioned above, not only is the timing of the action unpredictable, but so is its effect. However, since a central bank can print money and it has direct control of the levers that affect a currency's value, investors need to take this risk seriously.
The SNB in particular, and the BOJ to a lesser extent, seem willing to use all of their power to break the association of their currencies with the safe haven label. This will have major market implications as there are no obvious successors to this much-maligned crown.
The sovereign debt crisis rules out Europe, the pound has its own fiscal fires to fight and the Pacific currencies- the Aussie and the Kiwi – are still too dependent on global growth to take the mantle. Emerging market currencies are also off the list they are either tightly controlled (like China and Singapore) or have also tried to reduce pressure on their currencies by implementing capital controls (like Brazil).
If central banks get their way then the traditional relationships in FX markets will no longer exist. An absence of safe havens in currency markets is likely to boost the attractiveness of Treasuries and gold in times of market panic. But FX will never become a purely "risky" asset class like stocks because of the way in which it is traded.
The Bottom Line
In FX, inevitably there is something going up. While the traditional safe havens may no longer be as safe due to central bank intervention risk, the markets will instead concentrate on relative value. This means more work for traders as they get to work trying to sift out the weak currencies from the strong.
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By Kathleen Brooks: Research Director UK, FOREX.com