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Reasons for Central Banks to Intervene Forex Trading

Central banks intervene in the currency market and influence Forex trading when the nation’s currency is experiencing excessive pressure (either upward or downward). The main idea is to raise or lower the currency value by selling or buying it on the foreign exchange depending on where the price is heading.

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In this article, we will discuss how central banks’ intervention can influence your Forex strategies, as well as why and when it happens. We will also share some traders’ tips on how to behave during the Forex market intervention.

When Central Banks Intervene Forex Trading

As stated earlier, intervention is the main tool for central banks to lower the pressure from speculators on the nation’s currency. It happens when the price is either going up or drops. When it goes upwards, nothing serious can happen to the economy. However, if the value declines, it may have the following consequences:

  • Increasing prices on imported products and services triggered inflation and increased interest rates.
  • The nation buys more products and services than it can sell. It leads to an account deficit making the region dependent on foreign investors and capital flows. Once again, central banks have nothing to do but raise the interest rate and maintain the currency value.
  • A rising exchange rate and exports rising prices. As a result, the country witnesses an extreme economic slowdown. This may have enormous consequences, especially for countries that mostly rely on export.

These are the main drawbacks of the rapid currency rate change. However, those are mainly the consequences. How about the motives?

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Reasons for Central Banks to Intervene the Forex market

Motives can be different. To make things simpler, experts divide them into specific groups. They include the following:

  1. Managing Forex reserves. Central banks started accumulating their reserves after the Asian crises struck the global economy. It appeared to be one of the most effective tools to ensure the currency value even when out under the pressure.
  2. Ensuring liquidity. Intervention makes it possible for central banks to ensure enough liquidity on Forex exchange markets. Additionally, it helps to prevent the nation’s currency from experiencing additional stress.
  3. Limiting volatility. According to the latest surveys, many central banks try to limit the exchange rate volatility when intervening in the Forex market. They believe it will help to smoothen the trend path for the currency exchange rate.

As recent studies show, the intervention of central banks has proved to be effective when opposing the crisis. What’s more, more than half of all institutions are sure their intervention strategy had success during the international crises taking place between 2005-2012. However, experts say that this kind of intervention may only have a temporary effect.

Forex Market Intervention Types and Means

The intervention in Forex trading usually comes in different forms and shapes. It can be direct or indirect. Central banks utilize different means to force the process. Here are some of the most common types and forms of intervention.

Intervention type Intervention form
Verbal Intervention Indirect
Operational Intervention Direct
Concerted Intervention Direct and indirect
Sterilized Intervention Direct

Now, let’s have a closer look at each of them

Verbal Intervention

Also known as “jawboning”, it takes place when the central bank officials are planning to talk the nation’s currency up or down. It starts with just a proposal or threat to utilize the Forex market intervention.

Sometimes, it is enough to simply announce the currency is either overvalued or undervalued. It is one of the simplest and cheapest ways of intervention to apply without real detriment to the economy, interest rate, and other crucial financial parameters. At the same time, verbal intervention can be quite effective.

Operational Intervention

It is the opposite version of the verbal intervention, as central banks move from “talks” to actually buying or selling the currency.

Concerted Intervention

As a rule, it is the result of several countries teaming up and coordinating the direction of the further currency value movement. Generally, central banks of other countries can use their reserves to maintain the situation of their country partner.

Success depends on many factors. They include the number of regions and central banks involved, the overall intervention depth or amount, and so on. This type can be also verbal when the coordinating countries only express their concerns about the future currency value.

Sterilized Intervention

A type of intervention is when central banks sterilize the process of currency selling by going short on short-term securities. It helps to take excessive funds back into circulation.

How Intervention Influences Forex Trading

Not only can it influence the exchange rate but also other factors. The changes may happen via a variety of channels. They may include portfolio-balanced channels making traders rebalance their financial portfolios because of the central bank’s intervention. The expectations channel relies on the ability to set a precedent for future intervention. This may also cover information about the potential level of the exchange rate.

Order-flow channel is another way of influencing the Forex market. The concept is based on the idea that central banks have more detailed information about other market participants. As a result, they have more power and data to shape the market accordingly.

What Forex Traders Should Do During the Intervention

As a Forex trader, you should think of means that will ensure extra care during the central bank intervention. The most obvious one is to set stop-loss order. Experts do not recommend trading against the intervention currents, as a single sell order launched by central banks will trigger a series of stop-loss orders resulting in huge market gaps.

If you are ready to take the risk and trade against the market, make sure you place a stop-loss closer to your positions that you usually place under normal market conditions. Keep an eye on support levels, as they are probably the ones to be used by central banks to increase the currency value.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.