The foreign exchange market is the largest financial market in the world, with a daily trading volume of over $6 trillion. The market operates 24/7, with traders buying and selling currencies across the globe. The exchange rate of one currency against another is the price at which currencies are exchanged. These exchange rates are determined by supply and demand forces, but they can also be influenced by central bank interventions. In this article, we will discuss how central bank interventions can cause volatility in major forex pairs.
What are Central Bank Interventions?
Central bank interventions refer to actions taken by a country’s central bank to influence the exchange rate of its currency against other currencies. These actions can include buying or selling currencies in the forex market, changing interest rates, and changing reserve requirements for banks. Central banks can intervene in the forex market to stabilize the exchange rate of their currency or to correct imbalances in the economy.
Impact of Central Bank Interventions on Forex Markets
Central bank interventions can have a significant impact on forex markets, especially on major forex pairs such as EUR/USD, USD/JPY, GBP/USD, and AUD/USD. When a central bank intervenes in the forex market, it can create volatility in the exchange rate of the currency being targeted. For example, if the Bank of Japan buys large amounts of US dollars in the forex market, the value of the yen will increase, and the value of the US dollar will decrease. This can create volatility in the USD/JPY forex pair.
Central bank interventions can also create volatility in other forex pairs that are not being directly targeted. For example, if the European Central Bank (ECB) intervenes in the forex market to weaken the euro, it can cause the US dollar to strengthen, which can create volatility in the USD/CHF forex pair, even though the Swiss franc is not being directly targeted.
Types of Central Bank Interventions
There are two types of central bank interventions: sterilized interventions and unsterilized interventions.
Sterilized interventions are actions taken by a central bank to buy or sell currencies in the forex market while offsetting the impact on the money supply by conducting opposite transactions in the domestic money market. For example, if the Bank of Japan buys US dollars in the forex market, it will sell Japanese yen in the domestic money market to offset the impact on the money supply.
Unsterilized interventions, on the other hand, do not involve offsetting transactions in the domestic money market. These interventions can impact the money supply and inflation in the domestic economy. Unsterilized interventions are less common than sterilized interventions because they can have unintended consequences on the domestic economy.
Examples of Central Bank Interventions
Central bank interventions have been used by several countries over the years to influence the exchange rate of their currency. One of the most famous examples of central bank intervention occurred in 1992 when the Bank of England attempted to prop up the value of the pound sterling against the German mark. The Bank of England bought large amounts of pounds in the forex market, but its efforts were ultimately unsuccessful, and the pound was forced out of the European Exchange Rate Mechanism.
Another recent example of central bank intervention occurred in 2011 when the Swiss National Bank (SNB) attempted to weaken the Swiss franc. The SNB announced that it would buy unlimited amounts of euros to keep the exchange rate of the Swiss franc below 1.20 per euro. The SNB’s intervention was successful, and the exchange rate of the Swiss franc against the euro stabilized.
Central bank interventions can have a significant impact on forex markets, creating volatility in major forex pairs. Central banks can intervene in the forex market to stabilize their currency’s exchange rate or to correct imbalances in the economy.