The Third force
In addition to looking at fundamentals and sentiment, there is another force at work in the markets, and that is the central banks. They have significant power to move markets, at least temporarily. They most often “jawbone”, or talk about what they want, or what is right, or what they might do. Less often, because it is expensive to do, they actually intervene in the markets. For example, if a central bank wants their currency to weaken, they will sell their own currency and buy something else (commonly a basket of currencies). It takes billions, but it does work. Here are a few recent examples.
Roth, the chairman of the Swiss National Bank (SNB) declared back in March of this year that the CHF had risen too high against their trading partners in the rest of Europe (the EU25 constitutes 62% of their export market), imperiling their Current Account balance. The SNB actively intervened; selling Swiss francs and buying Euros to maintain 1.51 or so. You can see the initial effect (EUR appreciating against CHF), and the resulting tight trading band (+/- 150 pips) in the succeeding 6 months.
Another example is the $/JPY. The Japanese economy is export-driven, and their largest trading partner is the US (22% of the total). The BoJ is famous for actively intervening in the markets. You can see from this chart the level at which they get rather uncomfortable- about 88 or so. They actively intervened back in February. I am not sure about in October, but it certainly was a good level from which to be bullish.
Trichet has made many comments recently about the TWI (trade-weighted) strength of the Euro, and the weakness of the dollar. While the ECB is not likely to intervene, I imagine that any approach to the previous high of 1.60 will be met with a lot of jawboning.
While trading limits like $/JPY of 88 can be done with the spot, options offer alternatives when the spot exhibits very low volatility like the EUR/CHF. You can actually profit from no movement at all with spread structures, and very limited downside risk. The topic is beyond the scope of this article, but you can reach me at stafford.paul1@gmail.com.
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