Do Momentum Traders Profit from Central Bank Intervention in Australia?

Abstract

A number of recent studies have attributed the success of technical trading strategies in foreign exchange markets to central bank intervention. Arguments advanced in favour of this hypothesis contend that intervention is conducted to maintain orderly market conditions - not to make money - and as such, central banks may be willing to take a loss on their intervention operations. This paper investigates the relationship between momentum based trading profits and intervention by the Reserve Bank of Australia (RBA) in the U.S. Dollar - Australian Dollar ($US/$A) market. As the RBA's intervention policy underwent several regime shifts throughout the course of the study, the analysis should provide better insights into this relationship than has been possible in similar studies involving other central banks. This paper demonstrates that whilst a simple momentum trading rule is largely unprofitable in the absence of RBA intervention, it generates very attractive returns when taking positions in the opposite direction to the RBA during periods of intervention. The most profitable opportunities occur when the RBA attempts to smooth or correct a strong trend in the $A (particularly an aggressive depreciation) over successive days. This suggests that on occasions where the RBA 'leans against the wind', public resources are lost to speculators following momentum trading strategies. As such, the results from this study have important implications for both monetary authorities and foreign exchange traders.