The Four Rules Of Currency Intervention

by: David Merkel, CFA

With the US Dollar Index taking out an all time low previously set in 1992, I thought I would take this moment to discuss my thoughts about where the dollar is going, and what we might see along the way. If the dollar gets much lower against the major currencies of our world, I would expect to see some currency intervention to try to raise the value of the US dollar.

There are rules to effective currency interventions. There may be more than four, but here are the four that I know:

  1. Do the intervention on a day when the economic releases favor a stronger US Dollar.
  2. Do the intervention when traders are overconfident, and pressing their bearish dollar bets too aggressively. Catch them leaning the wrong way.
  3. Don’t do it alone. You will fail. You must get the central banks of most of your major trading partners to go along to create an impression of unanimity.
  4. Do it BIG. This is not a time to hold back; either do it BIG, or don’t do it at all. You want the currency traders to wish they had never taken up the profession.

You want to have at least three of these in play for an effective intervention. You want to create a genuine panic that feeds on itself, leading everyone to readjust their positions on the US Dollar, pushing it up, and winning the psychological battle against a lower US Dollar.

Easy, right? Well, no. In the short run, interventions work if done properly. They don’t solve the macroeconomic problems underlying the weak Dollar, though, and so toward the end of the shock move upward in the Dollar, I would be inclined to buy more foreign bond exposure. Why?

During the intervention, the participating central banks suck in US Dollars, and pump out their local currencies. In the case of the Fed, they sell foreign currencies and buy US Dollars. Most of these central banks have all of the US Dollar assets that they want already, and they understand the fundamental situation regarding the US Dollar. So, like OPEC in their ineffective days, where they would announce production cuts, and then everyone cheats, in this case, the Central Banks do the intervention, but then quietly recycle the US Dollar assets that they never really wanted to hold.

That leads to a slow retest of the levels that the intervention happened at, and eventually, breaking through the level, at which point, the Central Banks can try again, or give up. Eventually the response is a “give up,” after which, the US Dollar slowly overshoots and then finds a new temporary equilibrium level, and the rest of the world adjusts to it.

I’m leaving out a lot here. The internal political pressures to keep the Dollar from falling. The effects on export industries. The slowly growing willingness to buy US Goods and services. Rising interest rates in the US. Rising inflation abroad. And more.

The investment implication is this, though. Until an intervention happens, the path of the US Dollar is down. After it happens, the path of the US Dollar is down, until a new equilibrium is found. Economies are bigger than governments, and in the long run, governments can’t affect exchange rates.

Just stay on your toes, and be ready to buy non-Dollar assets after the coming currency intervention.