Trading managed currencies — exploiting central bank policies to make a profit

Managed currencies are those such as the Singapore and Hong Kong dollars, the Chinese yuan, the Russian ruble, where the Central bank doesn’t control the day-to-day fluctuations of the currency, but attempts to manage the direction of the trend by periodical interventions. The interventions are usually formulated through a floating or fixed currency band where the price is allowed to move within a range around a central point which are both set by the Central bank. Usually, only those central banks or monetary institutions with a significant reserve accumulation can aim to manage their currencies effectively, as countering the actions of the market can be costly.

The midpoint and the percentile range within which the price moves are sometimes held as a secret by central banks, and sometimes they are public. It is also possible that the central bank possesses no solid numerical long-term plan for the price range, but moves as the fundamental data flow and the political authority dictate. The policy choice is a secret in the case Singapore, is open in the case of the Hong Kong dollar and is partially public according to data in the cases of both the ruble and the yuan.

Before further explanation, let us say that the predictive power of government policies tends to diminish during periods of volatility and economic turmoil. Central banks are not run by wizards with crystal balls, and usually they do not possess confidence or willpower greater than that possessed by the experienced trader. As a result, policy errors, zigzagging, and conflicting signals generate a lot of noise through which the trader must wade his way to success.

The word “managed” in the phrase managed currency encapsulates the core of our strategy in trading this section of the market. The authorities make a commitment not to allow their currencies to move beyond the limits of a band, and they are ready to intervene when such a movement occurs as a result of chaotic market action. And, to the further benefit of the trader, newspapers, forex websites, and market news providers all declare the presence of central bank authorities when they do intervene. In many cases, the central banks also encourage the publication of their presence as they seek to intimidate and discourage those who want to counteract their policies. All that the trader would have to do to profit from such interventions is noting the direction of the intervention, and acting in accordance with it. Thus when we know that the technical indicators are showing extreme values (for instance RSI is at 20 or 80), there’s news flow speaking of intervention, and the central bank has already made its intention to prevent extreme price fluctuations clear, the trader can, with great confidence, make a counter-trend move with a reasonable stop-loss order, and expect to return a meaningful profit. This is a proven and well known method, with very high odds of success.

The behavior of the Monetary Authority of Singapore between October 2007 and April 2008 provides countless profitable examples for this method. In many cases where the RSI registered extreme values, the MAS would intervene, and as traders used the opportunity to pile in, large amounts of profits were made. Counter-trend interventions by MAS were usually easily detectable because of the very large movements in spot within seconds, and they were also noted by Bloomberg and financial news providers.

Conversely, between November 2007 and April-May 2008, the People’s Bank of China allowed the yuan to appreciate in a very regular, and predictable fashion, providing currency traders with a unique opportunity to register risk free profits. Because the central bank manages volatility in a punctual and strict fashion, the risk of any significant reversal was almost non-existent, and policy direction was communicated clearly and decisively by the chief of the institution.

Where do the pitfalls of this method lie? Obviously, the first and foremost obstacle to the success of a central bank is insufficient reserves, or lack of political will. Usually, a central bank will do all that is in its power to ensure credibility but if the market does not find its declarations credible, it has the power to invalidate the schemes of the institution. Similarly, markets are quick to punish those nations where financial policies are and improvised and revised in response to temporary developments. In spite of all this, given the very high level of uncertainty that the forex trader must be used to live with, following interventionist central banks can be a relaxing experience.

Currency interventions are especially difficult when they occur on an isolated basis against prevailing market conditions with insufficient reserves. Given how liquid and vast the forex market is, only exceptionally reserve-rich nations, like China or Singapore, or those with little need of external financing, like Saudi Arabia, can be confident that they have the clout to make their interventions work. On the other hand, markets treat those few Central Banks with respect, and they are unlikely to suffer from short term shocks, and their interventions and currency policies have credibility that is not found in other, less financially sound nations.

To repeat, managed currencies can be a source of great profit if they are traded with patience and consistency. The risks involved are usually much lower than those faced when trading floating currencies, with the one caveat that currency crises can quickly wipe out the gains of a long-time if the trader is not sensible with his stop-losses. The principles of sound money management, and low leverage are still valid when trading this type of market. One should avoid bubbles, and it’s not a good idea to chase excessive price movements, especially because the managed currencies tend to absorb a lot of tension by resisting market pressure, and if they break, the reactions can be very violent and fearsome.

We strongly advise the trader to concentrate on one or two managed currencies, if that is the method he would like to employ, to absorb the policy choices and principles of the Central Bank in question, and act in accordance with global developments. The transparency and independence of the Central Bank are both exceptionally important, because we would not want our guiding institution to zigzag or bow to political power, in essence invalidating its statements and policy declarations. Singapore and HK are good choices to begin trading this method.

Here is a list of some currencies with their Central Banks and their policy preferences.

USD/SGD: Controlled by the Monetary Authority of Singapore, this pair is one of the more predictable and easier for those who prefer this strategy. Because of the status of Singapore as an importer of necessities like food, the monetary authority of Singapore aims to control inflation through the currency rate, and its policies are regularly and clearly communicated at its website.

USD/CNY: Controlled by the People’s Bank of China, the yuan’s value depends on two important factors: the trade surplus of China versus the Euroland and the United States, and the unemployment situation of China’s rural regions. The central bank does not zigzag, however it’s policies are greatly influenced by the supreme leadership of the nation and their relations with the US government. PBoC allows the yuan to appreciate at times of economic boom and inflation, and generally holds it stable during recessions and economic turmoil.

USD/HKD: The HKD is pegged to the US currency at 7.8, but is allowed in a band of 7.75 to 7.85. Hong Kong’s economic policies are influenced greatly by developments in mainland China, but the nation has a currency board policy, and is mostly independent in its policy choices. The nature of the peg suggests an almost risk free trade in buying the HKD at 7.75 and selling it as it appreciates.

USD/RUB: The ruble is managed by the Central Bank of the Russian Federation. Its policy choices are determined by Russia’s external balance, and the price of oil and other commodities.