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The Case for Currency Intervention


Will central banks prop up dollar?

It's been a long time since the dreaded word intervention crossed the lips of currency traders. Euro-dollar is within whisker of the 1.60 level; yen-dollar is threatening to test 95.00 in the near future. Market participants are beginning to wonder - could concerted intervention be the next move? We take up the debate in this week's column.

Could there be Currency Intervention?

First let's clarify that we're talking about currency intervention, because it's one of the few things central banks haven't yet resorted to. Central bank intervention in the financial markets has been unprecedented in size and scope. With $200 billion pumped into the financial system, the Federal Reserve deserves credit for the historic moves they've taken thus far. However with that in mind, I don't believe the time is ripe for intervention.

First of all, when has a central bank ever intervened to buy its own currency at the same time they're lowering interest rates? Doing so would almost counteract the central bank's efforts. Furthermore, the only type of intervention that really works is coordinated intervention. But unfortunately central banks around the world have different priorities and these are priorities don't include a stronger dollar. The U.S. needs a weaker dollar to stimulate the economy. The Eurozone needs a weaker dollar and stronger Euro to curb inflation.

Listen, I am the last guy to argue central banks are eager to intervene in the markets. But if the dollar's move reaches crisis proportions they may have no choice. The Federal Reserve doesn't want a runaway dollar, nor does the European Central Bank (ECB), or the Bank of Japan (BOJ).

So far the Europeans have been the primary absorbers of dollar's weakness and they've tolerated it with clenched teeth. As we saw Wednesday in the IFO numbers, the Eurozone economy continues to expand at a relatively healthy pace. But it's one thing to see a slow steady decline and another to see a sudden collapse. European producers can manage their hedge book as long as volatility in euro-dollar remains contained. However, if we start to see 3-5% daily moves in the pair, the G-3 policy makers are not going to sit idly by.

They'll Jawbone First

Verbal intervention will come before physical intervention. Why spend the money when one word from ECB President Jean-Claude Trichet, Fed Chairman Ben Bernanke or the G7 would be enough to turn the dollar around. This happened following the Washington D.C. G7 meeting in 2006 and again in Dubai in 2003. In fact, that's exactly what the market is waiting for from Trichet. If he uses the word "brutal" again, that may be enough to trigger a sharp recovery in the dollar.

We May be Beyond It

Verbal intervention is find and dandy, but if we get a runaway market, stern warnings won't matter. Remember there's no momentum market like the currency market. 95% of our market is driven by speculators and once they see blood in the water they're going to pounce. Remember that pathetic $2 bill taped to the door of Bear Stearns (BSC)? Well don't be surprised if it takes two dollars to ultimately buy a single euro.

The global economy simply can't afford the idea of the dollar's value disintegrating in front of our eyes. Too many goods and services are still tied to the greenback and if we have rapid depreciation, most multinationals will be unable to hedge properly.

G-3 Intervention Would Require Panic

You're right, no one benefits if the dollar collapses. In fact, countries with currencies pegged to the dollar are already feeling the pain. Inflation is skyrocketing in the Middle East and across Asia. There have even been labor riots in the United Arab Emirates, indirectly related to the weakening dollar.

However, in order for the U.S. to agree to coordinated intervention, the dollar needs to fall more. It needs to reach the point where international investors start feeling worried about the notional value of the investments.

I also think the ECB won't start panicking until the euro-dollar breaks above 1.60. In 2004, the euro-dollar rallied 13 percent in two months before the ECB called the move brutal. If we count 1.59 as the high, the euro-dollar has only appreciated 10 percent over the last 2 months. A 13 percent move would put the euro-dollar above1.62.

It's the Velocity not the Amplitude

I think it's the velocity of the move that will matter not its absolute value. If euro-dollar appreciated slowly and steadily most corporations could adjust. However, eventually dislocations in the global economy would no longer be sustainable. But if we have a rapid move, intervention is inevitable. Markets never adjust calmly, they always go to extremes and force policy maker's hands.

The Last Thing

If you're right and there's coordinated intervention, it will have a long-term impact on the currency market. Over the past 30 years, coordinated intervention has triggered major turning points in currencies. The last time this happened was in 2000, when the euro-dollar fell below 85 cents. This represented the ultimate bottom in the currency.

This all comes down to whether you think this is just another run-of-the-mill financial crisis or the start of something truly serious. I'm afraid it may be the later. After blowing so many bubbles, I believe U.S. policy makers have run out options. The coming economic contraction will be far more severe and protracted than most market players think. The dollar will only be resuscitated with central bank help.
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