Intervention - the Bank of Japan

What is intervention? An attempt by a central bank to intentionally move the exchange rate. Essentially, interventions are attempts by central banks -- banks that govern the value of respective currencies -- to manipulate the currency's value. Interventions serve as a prime example of how key market participants -- like central banks -- need to be watched by all traders, as their actions can substantially affect exchange rate movement.

The most prolific example of interventions can be seen in the actions of the Bank of Japan. Japan's economy is dependent upon exports -- meaning its economy relies on selling its products internationally. Because of this, Japan's economy benefits from a weaker yen, as a lowly valued yen easily allows other nations to purchase Japanese products (and hence facilitates exports).

Since Japan's economy benefits from a weak yen, the central bank has a vested interest in ensuring that the value of the yen remains low. As a result, the Bank of Japan has intervened on numerous occassions in the currency markets, selling literally trillions of yen to drive the exchange rate down. For savvy traders, this presents an interesting and lucrative opportunity.
Let's take a closer look at how the Bank of Japan has recently intervened in the FX markets to drive the exchange rates downward.

Bank of Japan Attempts to Put a Floor Under USDJPY

The Bank of Japan (BoJ) intervened numerous times throughout 2003, in an attempt to ensure that the USDJPY rate would fall as little as possible. The pair had been falling rapidly, as U.S. dollar weakness coupled with yen strength led to a sliding USDJPY exchange rate. As a result, emergency meetings were held at all major export firms to assess their plans for handling the rapid appreciation in the JPY. By the end of the year, the Bank of Japan would spend over Y13 trillion (or $115bn) to sell the yen in the FX market to prevent its value from rising excessively.
The Bank of Japan started its new intervention policy in 2003 by intervening between the 115 and 116 levels. While their attempts at keeping the USDJPY above 115 were successful for some time, market forces eventually won out, and the pair made a sustained break through the 115 level in September of 2003. With the "invisible floor" of 115 cleared, traders felt comfortable that the Bank of Japan could not maintain a weak yen, and hence entered the market as buyers of yen and sellers of USD (or sellers of the USDJPY pair). The result was a sharp fall: the USDJPY pair fell about 600 pips in less than two weeks.

Prior to the sustained break below 115, participants experienced a few months of trading where they could legitimately expect the BoJ to intervene in the market around that level. As a result, many traders purchased USDJPY around the 115 level -- and reaped profits in doing so.

More recently, in early 2004 the Bank of Japan intervened in the currency market to keep the exchange rate of USDJPY above 105.00. This massive intervention pushed the USDJPY from just above 105.00 to above 112.00, a 700 pip gain in just a few weeks. The intervention coincided with the end of the Japanese fiscal year. The Bank of Japan drew a "line in the sand" just above 105.00, and intervened on a masssive scale.

Risks to Intervention-Based Trades
Clearly, intervention, or even failed interventions, can have a big impact on the FX market -- and hence should be something that traders keep an eye out for. Before seeing intervention as a quick way to easily profit, though, there are certain factors that traders should bear in mind before placing trades focusing on interventions.

Timing
The biggest risk of intervention-based trades is the timing of when intervention will occur. In the past year, the BoJ has intervened between 116-118. Although this level is known, 200 pips can be significant risk. Also, the exact timing is always unknown, so traders will typically need to hold their position for weeks -- with potentially large floating losses -- as they wait for intervention. Therefore unless traders have sufficient margin in their accounts to sustain losses, they could easily get a margin call prior to the BoJ stepping into market.

Sustainability
An additional risk is that, as we've seen, the BOJ cannot sustain intervention indefinitely. At some point, the artificial level the intervention is meant to uphold will have to fall. When exactly this will happen, though, is anyone's guess. A trader who had expected the intervention level to hold strong on September 17 of 2003, and thus had bought USDJPY, clearly would have experienced the downside of unsustainable interventions; the market fell strongly in the opposite direction, falling through the level and creating enormous potential losses for any trader who was counting on an intervention.

Key Points for Traders
There is no denying that intervention-based trades worked very well in 2003, as the Bank of Japan has spent over Y13trln to aggressively combat Yen strength. However, as we have seen, traders cannot take their presence for granted and assume that interventions will last indefinitely, nor can they know precisely when they will occur. Ultimately, traders will have to follow the news to help them determine whether or not an intervention will occur, and need to react accordingly based on their analysis.

Bank of Japan Intervention: How Traders Reacted
On May 19, 2003, USD/JPY reached a low of 115.07. The Bank of Japan, knowing that there was a "head and shoulders" formation with a neckline at 115, intervened to support the exchange rate. The BoJ knew that 115 was a signficant level, and that a break of that level may have induced traders to sell USD/JPY. Traders, using both the fundamental knowledge and technical levels, may have had a very profitable trade.

The head and shoulders formation is a chart pattern that includes a peak that returns to support (the shoulder), followed by a higher peak, which again returns to support (the head). The second shoulder occurs when the exchange rate fails to reach the peak of the head, and instead reaches the approximate peak of the left shoulder before falling once again to support.
The neckline is established as the common level of support, the low point reached by the exchange rate after the creation of each part of the formation. Once the price breaks below the neckline on the right side of the second shoulder, this is a signal to sell.