Currency Intervention vs. Speculative Sentiment: Analysis of Japanese and US FOREX Markets Xuxin Mao Feb 2012 University of Glasgow
Motivation and Plan Yen s Appreciation against USD is a puzzle in international finance even with Japanese and US interventions in April 1991-August 2008 period. No research addresses the FOREX speculative sentiment effects on the intervention. Claim: This effect is not only important for central banks and monetary policy, but also useful for FOREX trading/investment. Approach: I will first build a Cointegrated VAR model to incorporate both theoretical influence channels and suitable international parity conditions to analyze the short- and long-term intervention effects. In order to understand why neither channel works, I will include speculation variable into my model to emphasize the empirical speculative effects on different channels, which also provide possibility to develop more plausible theoretical models.
Theoretical Background -Influence Channels of Sterilized Interventions 1. Portfolio Balance Approach (Isard,1980;Branson,1984;Kumhof,2010) Necessary Assumption: Imperfect substitutability of domestic and foreign assets =>risk premium measured by deviations from uncovered interest parity t Empirical Results: t i t l i t l s t t Developed countries (Frankel,1982;Obstfeld,1983;Rogoff,1984;Lewis,1988): Effective at most in the very short term, the effects are very small in size Developing countries (Kumhof, 2010): more effective with large fiscal spending volatility and small domestic currency government debt
Theoretical Background -Influence Channels of Sterilized Interventions 2. Signalling Approach (Mussa,1981;Kenen,1988;Almekinders,1995) Assumption: Adaptive expectation (the interventions change the exchange rate expectations of private agents by changing their expectations of the actions of monetary authorities and their effects.) Operational Regression Form: Empirical results: Developed Countries (Mixed results): s t 0 1 Int 2 i t i t error Dominguez and Frankel (1993),Dominguez(1997): very substantial effects Humpage(1989),Eijffinger and Gruijters (1991): No effects Developing Countries (Few works has been done)
Literature Review of Methodology Since the mid of 1990 s, few theoretical papers have been produced; in addition, many empirical papers focus only the statistical effects of interventions which can be classified into four methodological groups: 1. Low-frequency time series (Taylor 2004,2005, Statmann,2005, Hillebrand and Schnabl,2008) : Endogenous effects may exist 2. Event studies (Fatum and Hutchison, 2003): Rather arbitrary definition of events makes comparison nearly impossible 3. High-frequency (Dominguez, 2003, Fatum and King, 2005) Lack of data availability and less political importance. 4. Identified model (Kim, 2003, Neely 2005, Kearns and Rigobon, 2005) Lack of theoretical foundations
Testable International Parity Relations and Variables Purchasing Power Parity (PPP) Uncovered Interest Rate Parity (UIP) Term Spread Parity Fisher Parity p t p t s t t s t i t l i t l t i b,t i m,t t r b,t i b,t E t p t l l real interest parity (RIP) r b,t r m,t i b,t E t p t l i l m,t E t p t s s The monthly data set is from the EconWin database with duration from April 1991 to August 2008 (Japanese and US Intervention data are from Bank of Japan and Federal Reserve Economic Data respectively, and COT data is from the Commodity Futures Trading Commission.) r m,t i m,t E t p t s s t s t the logarithm of the logarithm of the spot exchange rate USD/JPY (the rate at which one USD can be exchanged for Yen) p t the logarithm of the Japanese consumer price index p t the logarithm of the US consumer price index r b,t the Japanese 10 years bond rate/1200 r b,t the US 10 years bond rate/1200 r m,t the Japanese 3 months libor rate/1200 r m,t the US 3 months libor rate/1200 CumInt Sum of the Japanese currency interventions in unit of billion USD, positive if selling USD or buying JPY CumInt Sum of the US currency interventions in unit of billion USD, positive if selling USD or buying JPY COT Long to short ratio of speculators postions on Yen futures from Commitments of Traders reports of the Chicago Mercantile Exchange
Exchange Rates, Prices, Interests and Interventions
International Parity Condition Illustrations
Data Analysis (Cointergrated VAR Methodology (Juselius, 2006)) Start with smaller variable vector Transform I(2) variables to I(1) by expressing them in real terms. Hypothesis to be tested: Interventions are weakly exogenous X t X 1,t, X 2,t X 1,t pp t, p t, s t, i b,t, i b,t s t, p t, p t, i b,t, i b,t, CI, CI Partial error correction representation of VAR(2) model: X 1,t 1,1 X t 1 1 X t 1 A 0 X 2,t 0 D t 1,t X 2,t CI, CI Perform specification tests, analyze short-run effects adopted by signalling channel Rank=3, which means 3 possible cointegration relations After hypothesis testing of validity of Portfolio Balance Channel, an identified cointergation space will be constructed. Similar cointergration analysis by including LIBOR rates (rank = 4) to include more information and make the results more robust.
Counterproductive S-R Intervention effects and Failure of Signalling Channel Short-run significant counterproductive effects of Interventions on exchange rate movements (Failure of standard signalling approach), including libor rates does not change the results. pp t 2 p t s t i b,t i b,t I I 0. 001 3.84 0. 00 3.72 0. 016 2.80
Counterproductive L-R Intervention effects and Failure of Portfolio Balance Channel Single Parities, including UIP, are rejected, which fulfil prerequisite of Portfolio Balance Channel. With restriction tests and identification, the relevant cointegration relations: p t 0. 04s t 0. 0CI error i b,t i b,t 6. 88i m,t 1. 12i m,t 0. 001CI error The Overall Yen selling or USD buying interventions increase Japanese and US interest rate differential (Risk premium of holding Yen) and make more Yen appreciation. L-R counterproductive results which means Portfolio Balance Channel does not work.
Short-term Speculative Sentiment Effects Short-run counterproductive significant effects of Interventions (The failure of Signalling Channel) can be explained by speculative positions) When Japan intervenes with buying 1 billion USD or selling equivalent Yen, the long to short to yen futures will increase by 6.1% (more speculators will long Yen), with the result of more than 1 Unit of Yen appreciation against one USD within one month. pp t 2 p t s t i b,t i b,t i m,t i m,t I I 0. 001 3.34 0.000 3.16 0. 016 2.80 0.000 2.48 0.000 2.96 0. 000 2.57 0.000 3.04 COT 0.061 5.21
Long-term Speculative Sentiment Effects Relevant cointegration relations: p t 0. 003s t 0. 0COT 0. 0CI error 1. 059i m,t i m,t 0. 003COT 0. 0CI error The Overall Yen selling or USD buying interventions increase Japanese and US interest rate differential (Risk premium of holding Yen) and make more Yen appreciation through more Yen-buying Speculations.
Summary Because of dominant FOREX market speculations, neither of the two theoretical channels works, meaning that the US and Japanese interventions have counterproductive both short- and long-run effects. There is need for new theoretical models that investigate the effects of interventions by central banks, which also incorporate speculative effects. To fade the spike of a Yen-related intervention is a highlyprofitable FOREX trading strategy.
Note Before You Read My Paper To Whom may Concern, I just finished the final data analysis of speculation sentiment with the most important results presented in the slides for the conference presentation. However, as the deadline of submission approaches, I have to submit the following paper with only intervention effects considered. I will keep updating my paper and will send to you if you need. Thanks for your great consideration and look forward to hearing from you. Best regards, Xuxin Mao x.mao.1@research.gla.ac.uk