Central banks generally believe that it is necessary to intervene in the foreign exchange market to protect the value of their currencies. The central bank can buy or sell foreign exchange reserves, or simply mention that the value of a particular currency is too low or too high, and leave the rest to the foreign exchange market to accomplish the purpose of intervention. This article looks at different types of central bank interventions and points to keep in mind before trading.

Foreign exchange intervention refers to the process by which the central bank buys and sells foreign exchange in order to stabilize the exchange rate or correct the imbalance in the foreign exchange market. This is usually accompanied by subsequent adjustments to the money supply by the central bank to offset the unexpected impact of the intervention on the local economy. The above mechanism is called "sterilization intervention" and will be discussed later with other foreign exchange intervention methods.

Traders must keep in mind that when the central bank intervenes in the foreign exchange market, the trend of the foreign exchange may be extremely unstable. Therefore, it is necessary to set an appropriate risk-reward ratio and adopt prudent risk management measures.

When the current foreign exchange trend is opposite to the direction expected by the central bank, the central bank will intervene in the foreign exchange market. Therefore, trading around central bank intervention is similar to a trading trend reversal. In addition, the foreign exchange market tends to predict the intervention of the central bank, which means that it is not uncommon for the central bank to intervene in the opposite direction to the long-term trend. Because there is no guarantee that traders will be able to spot new trends before trading.

Central banks generally believe that intervention is necessary in order to stimulate the economy or maintain an ideal exchange rate. If the domestic currency appreciates to a level that makes the country’s exports more expensive than other foreign countries, the central bank will usually buy foreign currencies and sell domestic currencies. Therefore, the central bank intends to change the exchange rate to benefit the local economy.

The following is an example of a successful intervention by the central bank in the exchange rate of the yen against the dollar. The Bank of Japan believes that the yen exchange rate is not conducive to the Japanese economy, so it quickly intervened in the yen to depreciate it, causing the dollar/yen pair to rise. The intervention took place within the time span depicted by the blue circle, and the effect soon appeared.

Although most central bank foreign exchange interventions are successful, there are some exceptions. The chart below depicts the movement of USD/Brazilian real in foreign exchange intervention. In the two notes on the chart, the Central Bank of Brazil tried to prevent the Brazilian real from falling through intervention, but it was obviously unsuccessful.

The central bank can choose different types of interventions. These measures can be direct or indirect. As the name implies, direct intervention has a direct impact on the foreign exchange market, while indirect intervention achieves the central bank's goals with less intervention. The following are examples of direct and indirect interventions:

Operational intervention: The central bank intervention mentioned by people generally refers to operational intervention, which is a direct intervention method. It involves the central bank buying and selling foreign and domestic currencies to push the exchange rate to a target level. Promote the market through these domestic and foreign currency trading transactions.

Oral intervention: This is an indirect foreign exchange intervention measure. For example, the central bank announces that if the exchange rate reaches a certain undesirable level, it may intervene in the market. As the name suggests, this method is more about talk than actual intervention. When the central bank is prepared to intervene, traders will restore the exchange rate to a more acceptable level under the verbal influence of the central bank.

Coordinated intervention: This is a combination of verbal intervention and operational intervention. It is most effective when multiple central banks express the same concerns about the exchange rate. If multiple central banks increase their verbal intervention efforts, it is very likely that one of them will actually intervene to push the exchange rate toward the direction of common expectations.

Sterilization intervention: Sterilization intervention includes two actions by the central bank to affect the exchange rate while keeping the monetary base unchanged. This involves two steps: selling or buying foreign currency, and open market operations (selling or buying government bonds).

Risk Warning: The above content is for reference only, and does not represent JRFX’s position. JRFX does not assume any form of loss caused by any trading carried out in accordance with this article. Please consult your financial planner for your investment portfolios and manage your own risk.

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