The Conditions for Intervention

The US dollar appears to have become a one-way bet and with important psychological levels having been approached and official rhetoric having been ratcheted up a notch, it may be prudent to consider under what conditions central bank intervention is likely.

We have argued that the bar for intervention is relatively high. Fundamental factors still seem to point to the dollar’s downside. As recently as September, the IMF claimed the US dollar was still over-valued. The Federal Reserve began to cut interest rates in August and although some officials have played down the need for another near-term rate cut, the market is still highly convinced, judging from the Fed funds futures strip, that additional rate cuts will be forthcoming, with the next move at the Dec 11 FOMC meeting. In contrast, there is little likelihood of an ECB or a BOJ rate cut any time soon.

We have noted that the Bush Administration appears ideologically predisposed not to intervene in the foreign exchange market. Indeed, the current president appears to be poised to be the first US president not to authorize intervention since the breakdown of the Bretton Woods regime of fixed exchange rates. Moreover, we have noted that intervention would dilute and obfuscate the US claim, especially directed to China that currency prices, like other prices, should be set in the marketplace.

That the bar is high for intervention does not mean that the risk is stuck at a negligible level. If intervention can be conceived as an escalation ladder, official rhetoric appears to have climbed the low rungs already. Of course French President Nicolas Sarkozy and the French government have been staging a two-pronged battle. The first front that they opened was with the European Central Bank and Sarkozy’s old nemesis, fellow Frenchman Jean-Claude Trichet. Finance ministers throughout the euro-zone lent France little support in what was perceived as an attack on ECB independence and its informally granted currency mandate. In contrast, it took the US Treasury Department and the Federal Reserve several decades to work out the division of labor over currency policy. The second front was opened on Sarkozy’s visit to the US, where he beseeched US policy makers to do something about the dollar.

However as the euro approached the psychological $1.50 level, German Finance Minister Peer Steinbrueck seemed to acknowledge that official acceptance of the moves in the foreign exchange market had limits. On November 21 he warned that there was a “pain threshold”, even though he could not define it, adding “I’m aware of the fact that there is a limit”. He noted that the competitiveness of German companies ensured that the euro’s strength had not been a cause of worry, but was unable to say whether that would be sufficient going forward.

In the past it has seemed that major trends in the dollar have been reversed only with actually material and coordinated intervention. Coordinated intervention helped the US dollar carve out a low in the mid-1990s, after which then-Treasury Secretary Robert Rubin articulated the “strong dollar policy”. After the intervention in the spring of 1995, Rubin authorized intervention just one more time and that was in the spring of 1998 to sell dollars and buy yen alongside the Bank of Japan. The dollar continued to rise for a few months after that, but the dollar has not been as strong against the yen since then. Rubin’s successor Lawrence Summers authorized intervention once on his watch and that was in a coordinated operation to support the euro in the fall of 2000.

The case for intervention could be based on the need to stabilize the market, not the more ambitious objective of reversing the dollar’s slide. This would also be consistent with the G7 statements that warn that excessive volatility is not desirable. Implied 3-month euro volatility is near 9% currently, which is the upper end of the range over the past couple of years and is also well above the 100, 200 and 500 day moving averages (6.73%, 6.19%, and 7.18% respectively). In addition, the premium for euro calls over euro puts equidistant from the month

(3-month 25-delta risk reversals) are also as extreme as they have been over the last couple of years, which is also indicative of a one-way market.

The same general arguments apply to the yen, but even more so. Implied 3-month yen volatility is quoted near 12.5%, which is the upper end of the range that implied volatility has been confined to for several years and is well above the 100, 200 and 500 day moving averages (8.21%, 8.59% and 10.53% respectively). Also, the premium for yen calls over yen puts equidistant out of the money (3-month 25-delta) are as extreme as ever, including those periods in which the Bank of Japan was much more activist. Currently the yen calls are going for more than 5% more than yen puts. In the middle of August the premium briefly touched 6.5%. To put this in perspective, in recent years, the premium rarely exceeded 2%.

When the US and IMF press for more flexible currencies, many countries often experience it as more volatile currencies. Intervention at extreme market conditions would help ease fears that floating currencies means abdicating official responsibilities in favor of letting speculators drive currency values entirely.

Another justification for intervention was suggested by former Federal Reserve Chairman Alan Greenspan. At a conference in Norway (today November 23), Greenspan opined that policy makers may need to address the weakness of the dollar if it threatens to fuel inflation. “To the extent that a weaker dollar,” he said, “is of such a magnitude that it creates serious problems, it needs to be addressed by policy makers.” But this was not just a case of hypothetical musing. Greenspan said inflation is “becoming the critical issue” for central banks.

At first blush, this may sound counter-intuitive. Why should a stronger dollar against the euro help stem European inflation? Conventional wisdom holds that the euro’s strength helps curb inflation. For example it helps offset the increase in oil prices. But does it really? Crude oil prices have rallied almost 50% this year, while the euro has appreciated by about 12% against the dollar. In October, euro-zone consumer prices rose 2.6% above year ago levels, and matches the pace in September 2005, which itself was the highest since the spring of 2001 and this despite the euro’s march higher. In a similar vein, the yen’s weakness has not pushed up inflation in Japan. Japan has not reported a positive year-over-year CPI figure this year. Stabilization in the dollar could help stabilize commodity prices and through that channel may help contain inflation.

An additional benefit of a more stable dollar would be on market psychology, even if the dollar bears get their fingers burnt in the foreign exchange market. The subprime and derivative related losses as well as the paralysis that has hit a wide swathe of the capital markets coupled with the persistent dollar decline and now a brutal decline in global share prices has fueled a sense among investors that market conditions are out of control. Official action could help assuage the fragile sentiment.

The argument presented here should not be read to suggest that intervention is imminent. There are still a number of obstacles to intervention. The chief obstacle, as Steinbrueck hinted at, is that the pain threshold of decision makers has not yet been reached. If the US indicated its pain threshold was at hand, it would seem somewhat straight forward to get ECB support. It depends on how the intervention is coordinated and whether it would include dollar-yen as well as euro-dollar, and how enthusiastic Japan’s participation would be. That said, Japan’s support could be secured if the BOJ largely executed trades on behalf the ECB and/or Fed rather than for its own account.

Coordinated intervention when the market is over-stretched and has begun correcting may prove effective even if the intervention is not backed up by adjustments in monetary policy. Of course, coordinated intervention, when the market positioning is at an extreme, coupled with an ECB rate cut would increase the likelihood of a successfully intervention operation.