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What Are The Three Signs Of A "Disorderly" Currency Market: Richard Koo Explains

One of the biggest ironies in recent months has been the Bank of Japan's recurring insistence that it would promptly intervene in the FX market if the ongoing "disorderly" moves in the Yen do not stop. This was ironic because it was the BOJ's own insistence in characterizing virtually every move as disorderly that ultimately led to the most disordely move of all this week when following the BOJ's "disappointment" in failing to do anything, the Yen soared the most in years, to a level not seen since October of 2014. Now that was a truly "disorderly" move, which was only made possible by the BOJ's constant and misguided rhetoric.

 

Then just yesterday, the Treasury unveiled a brand now "monitoring list", on which it put five economies but most notably China and Japan. And once again, that word "disorderly" appeared.  This is what the Treasury said:

Economies with flexible exchange rates hold reserves in order to intervene in foreign exchange markets to prevent a disorderly depreciation of their currencies.

Not only that, but the Treasury made it clear that it would very explicitly frown on any "disorderly" currency depreciation by US trade partners going forward.

The United States has secured commitments from the G-20 member countries to move more rapidly to more market-determined exchange rates, avoid persistent exchange rate misalignments, refrain from competitive exchange rate devaluations, and not target exchange rates for competitive purposes. Through Treasury’s leadership, the G-7 member countries, including Japan, have publicly affirmed that their fiscal and monetary policies will be oriented toward domestic objectives using domestic instruments.

But if the BOJ was so perilously wrong in its characterization of what disorderly exchange rates are, then what are they? For the answer we go to Richard Koo and the following explanation.

What is meant by “orderly” exchange rate movements

 

At the press conference following the meeting of G20 finance ministers and central bank governors in Washington on 15 April, Treasury Secretary Jack Lew responded to Finance Minister Aso’s expression of “strong concern” about “one-sided” increases in the yen the previous day by saying that “despite recent yen appreciation, foreign exchange markets remain orderly.” This comment made it far more difficult for Japan to engage in currency intervention.

 

The operative term in this exchange was “orderly.” Currency authorities in the developed economies have a basic agreement to leave the determination of exchange rates up to the market. The one exception to this rule is that national authorities are allowed to intervene, even unilaterally, when markets become “disorderly.”

 

There is a proper definition for what constitutes a disorderly market. When I worked as an economist at the New York Fed’s forex desk, the definition was divided into three stages.

 

First sign of disorderly market: widening bid-offer spreads

 

The first sign that a market has grown disorderly is that forex dealers’ bid-offer spreads (the difference between the prices they are willing to buy and sell at) start to widen.

 

For instance, a normal bid-offer spread of 0.03 yen might rise to 0.05 or 0.10 yen as market conditions become turbulent. Spreads increase because exchange rate volatility forces dealers to provide themselves with a wider margin of safety.

 

Second sign: gapping

 

If the market turmoil continues, the next phenomenon witnessed is something called gapping. This happens when there is a discontinuity between the bid-offer quotes submitted by dealers.

 

For example, if one dealer says it will buy at 110.25 yen/dollar (bid) and sell at 110.30 yen/dollar (offer), the next quote will usually overlap that range. In this case, it might be 110.27–110.32 or 110.23–110.28.

 

But when even dealers are no longer sure what is going on in the market, the original quote of 110.25–110.30 might be followed by a non-overlapping quote of 110.35–110.40. Such moves are also likely to be accompanied by a widening of bid-offer spreads.

 

In extreme cases, dealers stop answering their phones

 

In the final stages of a disorderly market, when extreme turmoil leaves all participants unsure what to do next, dealers will simply stop answering their phones. By having traders connect to other internal extensions, the firm can keep all its phone lines busy and avoid taking any outside orders.

 

This is a disorderly market, and in such cases central banks are allowed to intervene in the currency market to restore order.

Now, as even Jack Lew admits, central bank intervention in a disorderly market is fine. A far bigger risk in game theoretical terms, as well as angering the global reserve currency hegemon, is when a central bank intervenes when the moves are perfectly orderly; this is precisely what the market was convinced the BOJ would do on Wednesday night... and was massively wrong.  According to Nomura's Koo, the answer is that "Japanese intervention in orderly forex market could be seen as collapse of cooperative relationship"

This sort of phenomenon has yet to be observed in the yen’s current upswing, which is why Mr. Lew went out of his way to describe forex markets as “orderly.”

 

If Japan were to unilaterally intervene to weaken the yen under such conditions, it would be doing so without US approval, which would signal a rift between the two countries.

 

Japan is, of course, a sovereign nation and is free to intervene if it so desires. The problem is how the market might react to a perceived collapse of its cooperative relationship with the US.

It happened once before under Eisuke "Mr Yen" Sakakibara., when the Japanese finance minister intervened in 1999 against US wishes. This is what happened then.

Problems [in Japan's relationshbip with the US] surfaced late in June 1999, when then-Vice Minister of Finance Eisuke Sakakibara, perhaps seeking to celebrate his impending retirement, declared his intention to push the yen down to 122 versus the dollar from the existing level of 117 and implemented an intervention totaling several trillion yen.

 

This action, which was not only unilateral but was against the wishes of the US, seriously upset US Treasury Secretary Lawrence Summers, who was already jittery over the trade frictions between the two nations. Mr. Summers quickly distanced himself from Japan’s intervention in no uncertain terms.

 

The markets took this official exchange as evidence of a breakdown in the cooperative relationship between Japan and the US that had been in place ever since the Louvre Accord in 1987. Helped by the fact that Japan was running a large trade surplus at the time, the yen strengthened and USD/JPY, instead of heading towards 122, plummeted to 102.

 

Not only did Japan experience heavy foreign exchange losses, but the economy now had to deal with a sharply higher yen. The Assistant Treasury Secretary for International Affairs at the time, Timothy Geithner, is reported to have shouted at a Japanese counterpart, “Didn’t anyone try to stop him [Sakakibara]?”

Perhaps the BOJ's January NIRP announcement was also a unilateral decision without prior approval from the US, which explains why the USDJPY instead of soaring, has tumbled to nearly 2 year lows.

One thing is increasingly certain: the US has finally put its foot down, not surprisingly at a time when the USD is rapidly sliding. Maybe the period of strong dollar generosity for the rest of the world, has come and gone, and from this point on it is time for the US to reap the benefits of a rapidly depreciation currency especially since the threat of any rate hikes is virtually gone. That said, we won't know for sure until Goldman finally capitulates on its dollar call which has been "long and wrong" for the past six months. Only when Robin Brooks finally throws in the towel, will it be safe to once again go long the USD.