Global Briefing: The Forex Rubber Band Continues to Stretch

Don't underestimate the effectiveness of well-timed intervention in the foreign-exchange market.
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The euro finally fell through the $1.00 level at the end of last week. The market is encouraged that European officials did not express too much concern over the external value of the euro.

Japanese officials are more concerned about the value of the yen and actually intervened to try to slow its rise. And although the yen finished last week slightly softer against the dollar, it is difficult to say the intervention was very effective.

Initially, the market thought the size of the intervention was relatively modest, a couple of billion dollars at the most. Slowly, however, estimates have risen. The

Federal Reserve

acts as a custodian for foreign central banks and other official institutions. The Fed's custody holdings jumped $13.43 billion in the week ended Dec. 1. Of course, this may reflect more than the

Bank of Japan

investing the dollars it bought in the foreign-exchange market, but that was likely a large part of the story.

In back channels, U.S. officials have apparently made it clear they are not inclined to intervene in the foreign-exchange market. The question is not only why should the U.S. intervene, but also if it were to intervene, should it sell dollars against the euro or buy dollars against the yen? Given the relative stability of the trade-weighted dollar, it is clear that currently the dollar is not a very salient variable in the policymaking equation.

When we buy a stock, we are theoretically buying a claim on a future earnings stream. However, when we buy a currency, it is not exactly clear what we are buying. And because, in their pure form, currencies do not generate an income stream, they are difficult to model. This contributes to the currency market's penchant for overshooting, which is a euphemism for extreme price swings that are not sustained for very long.

Recall the end of last year. The dollar got hit hard against the yen and European currencies. Many market participants attached structural or long-term reasons for the selloff. But as we know, the dollar bottomed against the European currencies at the start of the year and hasn't looked back. The dollar's price action against the yen is more difficult to sum up in a pithy way, but after falling from above 140 yen in July 1998, the dollar fell to below the 110 level in January 1999 before moving back above 120 yen for most of the second quarter.

Recall 1987 -- after the October equity market crash, the dollar collapsed. In the first trading day of the new year, the European central banks intervened and repeated their intervention over the next several days, and this helped put a floor under the dollar.

The lesson I draw from these examples and other such occurrences is two-fold. First, it is dangerous to attribute structural factors to short-term price action. Second, apparent trends at the end of the year are often, but not always, reversed early in the new year.

Many participants seem confused about intervention. Observers argue that intervention cannot be effective because the market, which sees turnover of $1.5 trillion a day, is far and away bigger than the central banks individually or collectively. This, of course, is a simple and verifiable fact.

But the inference is wrong. What made the U.S. and BOJ intervention effective in July 1998 was its timing and savvy execution, not that it was substantially larger than other interventions. Indeed, that intervention operation was smaller than the intervention operation around Easter 1998, when the Fed intervened on behalf of the BOJ. As a rule of thumb, U.S. intervention tends to be smaller and executed with more strategic finesse than Japan's, which relies on trying to overwhelm the market in sheer size.

Some participants are also confused about the significance of sterilization of the intervention. Sterilization occurs when, for example, the BOJ intervenes to sell yen and buy dollars in the foreign-exchange market, and then offsets the increased supply of yen by draining liquidity from the money market. Major central banks tend to habitually sterilize intervention. When the U.S. and the BOJ jointly intervened in July 1998, the intervention was sterilized, and few if any tried to resist the central banks because the intervention was sterilized. A working paper at the Fed argues that when money-market rates are close to zero, the difference between sterilized and unsterilized intervention is inconsequential.

I would suggest that intervention may be better understood as a band with many channels. The impact on relative money supplies is only one channel. Another channel might be a signal of policy intentions. Another channel may be the impact the intervention has on perceptions of risk. At times, the currency market may appear to be a one-way bet. Under such conditions, timely intervention may give speculators a healthier sense of two-way risk.

Bottom line: Don't be surprised if current trends are reversed in the new year. And although the likelihood of coordinated intervention is remote, don't underestimate the effectiveness of well-timed sterilized intervention.

Marc Chandler is the chief currency strategist for Mellon Bank. At the time of publication, he held no positions in the currencies or instruments discussed in this column, although holdings can change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

mchandler@erols.com.