Fighting Central Banks

This week’s newsletter is going to explore a little bit about why a central bank may intervene in its currency, and how we can trade (or not trade!) this development. First, we need to understand a little bit about Economics 101, particularly WHY a central bank may want a stronger or weaker currency.

When I refer to Economics 101, it merely means this is the theory behind why certain things are done, according to our basic textbooks. As we have all learned in real life, what is taught in school isn’t necessarily how things really work!

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The very basics are that you and I want a strong local currency because when we go shopping at our local neighborhood superstore, car dealership, or electronics store, imported goods are cheaper relative to our own currency. The longer our currency strengthens against another currency, theoretically, the cheaper these imports should become.

The central banks and government want a weaker local currency as it helps our country’s exports which should help Gross Domestic Product, trade deficit, employment and pull forward domestic demand, therefore, increasing tax receipts. While many central bankers when interviewed SAY they want a strong currency to give the hint that they aren’t manipulating their currency, what they say vs. what they do is often different.

From the blue arrows indicated on the above daily chart, you can plainly see the result of the Bank of Japan’s September 15th intervention where the USDJPY rallied approximately 300 pips and held for about three days. The second and third interventions resulted in much less of a move and didn’t even hold for a single day! (While direct evidence of the second and third interventions are more difficult to come by, interviews with several analysts and traders indicate the Bank of Japan was behind these very short-term counter trend moves.)

So what we have is an obvious downtrend on two long-term charts, which leads many traders to look for short positions. The trend is your friend right? But trading with the trend is only one thing to consider in our trades. When entering a trade, we must also look for our two exits – where must our stop loss be located, and where is a reasonable place to exit for profit. In a downtrend, the profit target generally goes where this pair bounced before and the stop loss above the previous rally or swing high.

Looking at this 120 minute chart, how many stop loss orders were hit on these different JPY interventions? Hard to tell, but I would guess thousands! So we have ourselves a bit of a dilemma. Knowing we want to trade with the longer term trend, but the central bank is trying to change the trend, what should we do as traders? We have several choices. The first is don’t trade it! I personally took a few weeks off from trading any JPY pairs as the added uncertainty and occasional volatility spikes didn’t fit into my trading plan. Knowing that the market is always going to be stronger than any central bank intervention would lead a stubborn trader to keep selling short. However, having your stop loss hit on these interventions could be a costly mistake!

The second choice you have is to trade smaller position size. Taking a hint from George Soros and believing that any central bank’s intervention will only last for a short time, we could still trade with the bigger trend knowing that another intervention may happen and take out our stop loss. With this possibility in mind, trading smaller position size makes sense so you can still be in a longer term trend, but also lessen your losses if your stops get hit. Always remember to sell into a supply zone and buy in a demand zone, maximizing your risk to reward ratio.

A third choice suggested to me by a student in class was to look for trades going along WITH the central bank’s desired currency direction. Logically, it makes sense to enter a trade where the central bank previously “defended” a level – defended basically means the price where the central bank came in and started trading the currency pair. Looking at the previous chart, you can see this technique didn’t work out very well.

Knowing WHY a central bank wants to intervene in their currency is a factor in trading, but knowing WHEN they will do it is the hard part. All we can do as traders is accept the fact that we may have our stop loss hit when this happens. Provided you still stick with the bigger picture trend and always take the small losses that are inevitable in trading, unexpected currency interventions shouldn’t cause any undue stress.

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