Currency traders were well and truly off piste last week when the Swiss National Bank (SNB) announced that it was intervening in the currency markets to weaken the Swiss Franc. But will their action lead to a devaluation free for all?

Introduction
On March 12th markets were awaiting the fairly mundane announcement of a further cut in interest rates by the SNB. The central bank duly obliged with the expected 0.25% cut, taking rates down to 0.25%.

However, the Bank then stunned traders by announcing a series of measures that included selling the Swiss Franc to buy foreign currencies. Before you could shout, “Avalanche” the currency had plunged by over 3% against the Euro and 3.5% against the Dollar.

So why was this such a big deal? In this two-part blog, Part I will take a look behind the scenes of the Swiss move and Part II will question whether intervention works and whether, as traders, we should be on the lookout for any other official currency moves.

How Does Intervention Work?
Intervention can follow one of two main routes.

1. The ‘Cheapskate version’ begins with a lot of talk (verbal intervention) and can take the direct route, “We’re concerned at the level of our currency and stand ready to take the appropriate action,” or the softer approach, “We’re quite happy to let the markets determine the level (don’t worry lads, we won’t ambush you if you want to keep selling)”. I reckon the UK used this tactic recently to get a lower, more competetive currency.

   For added effect the direct route can be supported by central bank dealers ‘checking prices’ around the market. This can give the impression that action is imminent, but is ultimately a short-term bluff.

   Verbal intervention can escalate with central banks from several countries all reading the same script, and sometimes this is enough to persuade traders to move on to the next game in town. On other occasions the bluff will be called, forcing the central bank (or banks) to intervene directly in the currency market.

2. The ‘Shock and Awe version’, favoured by the Swiss, is to take the market completely by surprise. There’s no warning; the announcement is reinforced by central bank dealers placing orders around the market. In some cases the central banks of several countries will participate in co-ordinated action.

   There’s also the coded version of intervention favoured by the US. Usually, when some-one from downtown Washington says, “We always favour a strong Dollar,” it means, “please keep on selling it, but you’re on your own if they capture you.”

   Central banks have a few tricks up their sleeves to get maximum bang for their buck. The Swiss were bang in line with their efforts, but banks can target a quiet market time (such as a US holiday, or the Asian time zone) where their size will have a magnified effect on illiquid markets.

   Also, the banks can wait for traders’ positions to reach an extreme before hitting them with the news. This will cause maximum panic as traders rush to close down their bets.

Some Previous Interventions
In 1998 the US and Japan joined forces to strengthen the Yen. The Asian financial crisis had seen the Yen weaken to Y144 and China was thought likely to devalue its Yuan if the Yen fell to Y150. The shock intervention sent the rate rattling down from Y143 to Y136 on the day.

In 2003-04 Japan returned to the markets, this time selling Yen to buy Dollars. This policy response to Japan’s deflationary period meant printing money which was used to buy Dollars, thus making Japanese exports more competitive.

Last November speculation intensified that the Japanese government would start to intervene to drive the Yen lower.

The Yen had appreciated by 20% against the Dollar and Euro in October as the credit crunch forced a rush for the door to close down carry trades . This involved selling riskier high-yielding investments and buying Yen to repay cheap Yen-denominated loans. The Japanese finance ministry had said they were ready to act if necessary in a move that was verbally supported by the G7. In the event a December rally in equities saved the day with the Yen shying away from the key Y80-85 level.

What Was Special About Switzerland?
Switzerland was a paradox; historically the currency benefited from a safe haven status (presumably because it’s the peace-loving home of the Red Cross and several very large and secretive banks). The global financial turmoil saw safe haven flows push the Swiss Franc to a record SwFr1.43 against the Euro.

At the same time the economy was in a bit of a mess. In the fourth quarter of 2008 GDP fell by an annualised 1.2%; the SNB forecast for growth in 2009 is -2.5-3%. And with exports making up 40% of GDP a currency at record highs didn’t sit well with the gnomes of Basle. But their biggest concern was deflation and the effect it would have on their banking sector; inflation is forecast to fall by 1% in 2009, recovering to just zero for the next two years.

This was all too much for the normally non-interventionist bankers who decided that the Country must have a lower currency to survive. This led to the events of last week.

In Part II I’ll have a look at whether intervention works, and what other currencies might be worth shorting as they jump on the Red Cross Bandwagon.