FYI | Aug 28 2008
By Greg Peel
It is the nature of financial markets and their rapid dissemination of information that intervention by certain authorities into the markets need only be hinted at and not necessarily implemented in order to achieve the same result.
One example is the monetary policy activities of central banks. A central bank maintains a chosen level of cash rate by either removing excess liquidity from the system or injecting fresh liquidity to the system each day in what is known as “open market operations”. If you make the right liquidity adjustments, institutions will be corralled into borrowing and lending at the desired cash rate.
If the central bank then wishes to change its monetary policy this implies it would have to make one big adjustment that day – remove funds if tightness is desired (a rate hike) or inject funds if a looser policy is required (a rate cut). However, financial markets are fluid, hence the reality is the central bank need only announce its rate hike/cut to the market and the market will adjust itself accordingly. The central bank then need only clean up the scraps.
But take this one step further, and we find that if the market believes a central bank is going to make a rate change then it will react before that rate change occurs. The Australian money markets are a case in point at present, having already factored in a 25 basis point cut from the RBA expected next week. The US markets had been “out-cutting” the Fed all the way down from August last.
The problem arising from the Fed’s slashing of the US cash rate from 5.25% prior to August ’07 to 2% in April ’08 was that the US dollar reacted by falling to its lowest ever levels against the currencies of its major trading partners. Aside from the fact the US government is always in favour of “a strong dollar”, this slide put significant pressure on the export industries of the other major trading blocs of Europe and Japan, who had elected not to cut their cash rates in the face of the credit crunch.
The finance ministers of the G7 nations met in February to discuss, among other things, the collapsing US dollar. Observers were waiting for talk of possible dollar intervention, but nothing specific was forthcoming. But when Bear Stearns went under in March the US dollar hit its lowest point. The markets were now crying out for some sign of what the G7 may really be planning. On March 18, FNArena reported:
“A hint on possible intervention in the dollar was dropped by Japanese finance minister Fukushiro Nukaga yesterday. ‘We will cooperate with European and US currency authorities and will monitor markets very carefully,’ Nukaga told reporters, adding that currency fluctuations had been excessively volatile. Reuters reports one Japanese forex manager as noting that these comments were a shift away from the usual finance ministry rhetoric, thus elevating the chance of intervention.”
As it was, the US dollar bounced in March after the Bear Stearns rescue, but was slip-sliding away again by April when the G7 finance ministers met once more. Again no announcement of intervention in the dollar was forthcoming. But this is what FNArena reported at the time:
“However, commentators were just a little excited. Following their regularly scheduled meeting over the weekend, this time in Washington, US Treasury Secretary Henry Paulson, as spokesman, did warn that recent ‘sharp fluctuations’ in exchange rates risk hurting the US dollar. This ‘new language’ was the most significant change to the G7 stance on exchange rates, Bloomberg points out, since February 2004 when the G7 last cautioned against ‘excessive volatility’.”
In response to ongoing criticism for the lack of inaction, one European G7 participant was quoted at the time as effectively saying “Take a hint”.
And so the forex markets took the hint. There were a couple more scares, but the euro never meaningfully traded any higher than US$1.60 – the level widely considered as the “line in the sand”. Beyond this line, the market believed, intervention would follow.
So why would you buy euros at US$1.60?
The US dollar is now 9% off its lows, having recovered on the relative effect of weakening European and Japanese economies. Now that the dust has settled, Japan’s Nikkei newspaper has today revealed that the US, Europe and Japan had indeed drawn up plans for a US dollar rescue back in March. The plan was to be enacted on the weekend of March 15-16, which will forever go down in history as “Bear Stearns weekend”, were the US dollar to go into a freefall following the investment bank’s collapse late in the previous week. On that weekend, the Fed and JP Morgan were madly tossing together a rescue plan for the failed bank.
As history shows, the US dollar actually recovered on the news of the Bear Stearns rescue, insomuch as the accompanying 75 basis point rate cut from the Fed did not spark the “freefall” the Big Three were fearing. The intervention plan remained on stand by only.
The forex market knew where the G7 stood. The hints were enough. The G7 may not have intervened directly, but as the market adjusted to an intervention stance it was as if they had anyway.
The newswires are today running hot with revelations of this intervention plan, however the news is not exactly a bombshell. Yet as one wire pointed out, the George W. Bush Administration looks like being the first since the US dollar became the global reserve currency not to preside over some form of dollar intervention. Perhaps the explanation lies in the fact the US Treasury secretary in the Administration – Hank Paulson – is ex-Goldman Sachs. He knows how the markets work and he probably had faith they would do what was needed, all by themselves.
