Technical Analysis and the Profitability of U.S. Foreign Exchange Intervention

By Neely, Christopher J. | Federal Reserve Bank of St. Louis Review, July-August 1998 | Go to article overview

Technical Analysis and the Profitability of U.S. Foreign Exchange Intervention


Neely, Christopher J., Federal Reserve Bank of St. Louis Review


Recent research has discovered two seemingly contradictory facts about U.S. intervention in foreign exchange markets. On the one hand, extrapolative technical trading rules trade against U.S. foreign exchange intervention and produce excess returns - returns in excess of nominal interest rates - during these periods, and U.S. intervention itself, is profitable over long periods. LeBaron (1996) and Szakmary and Mathur (1997) have shown that excess returns to technical trading rules are high during periods of central bank intervention and that the technical rules trade contrary to the direction of official intervention. Along the same lines, Neely and Weller (1997) have shown that trading rules constructed by genetic programs can use information on the direction of U.S. intervention to increase their excess returns in some exchange rates: When the Federal Reserve is buying dollars, traders following technical rules are usually selling dollars and profiting handsomely Some - Dooley and Shafer (1983), Corrado and Taylor (1986), Sweeney (1986), Friedman (1988), and Kritzman (1989) - have interpreted these results to confirm long-held conjectures that U.S. authorities' intervention creates excess returns for speculators and that public resources are being lost to speculators. These results certainly suggest that investors should trade contrary to U.S. intervention. In contrast, Leahy (1995) has found that U.S. foreign exchange intervention has been profitable for U.S. authorities, so perhaps investors would be wise to trade with them.

The relationship between trading-rule returns and central bank intervention is important because it might shed light on the source of technical trading-rule profits that seem to contradict the efficient-markets hypothesis. The profitability of U.S. intervention operations has been studied primarily because of Friedman's (1953) argument that there is a connection between the profitability of intervention and the ability of intervention to stabilize the market.(1) This link is tenuous, however. Salant (1974), Mayer and Taguchi (1983), and De Long, Shleifer, Summers, and Waldmann (1989) provide counterexamples.

How can technical traders make excess returns when they take positions contrary to U.S. intervention while U.S. intervention itself is profitable? On whom is the smart money to bet? This article first extends recent research linking U.S. intervention and trading-rule returns. It then confirms that U.S. intervention has been profitable over long periods. Finally, the article presents some explanations, consistent with the data, that may reconcile this apparent contradiction.

CENTRAL BANK INTERVENTION

Central bank intervention is the practice of monetary authorities buying and selling currency in the foreign exchange market to influence exchange rates. In the United States, for example, the Federal Reserve and the U.S. Treasury generally collaborate on foreign exchange intervention decisions, and the Federal Reserve Bank of New York conducts operations on behalf of both.(2)

When a central bank buys (sells) its own currency in exchange for a foreign currency, it decreases (increases) the amount of its currency in circulation, lowering (raising) its domestic money supply. By itself, this transaction would influence exchange rates in the same way as ordinary domestic open market operations; however, most central banks routinely "sterilize" their foreign exchange operations; that is, they buy and sell domestic bonds to reverse the effect of the foreign exchange operation on the domestic money supply (Edison, 1993). For example, if the Federal Reserve Bank of New York bought $100 million worth of deutschemarks (DM) in a foreign exchange intervention, the U.S. monetary base would increase by $100 million in the absence of sterilization. Other things equal, interest rates and prices would also change. To prevent changes to domestic interest rates and prices, the Federal Reserve Bank of New York would sterilize the intervention - sell $100 million worth of government securities - and absorb the liquidity. …

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