Earlier this month (on January 15) an obscure bank in an obscure country took an obscure action that stunned markets, caused bankruptcies, humbled hedge funds and caused unexpected margin calls for thousands of (mainly retail) currency traders across the globe.(1) Investors everywhere wondered what in the world was going on.(2)
My view – spoiler alert! – is that the market volatility presages a world we are about to enter, as confidence in the world’s central bankers withers and economic players are forced to live in the real world of real economic forces once again. Like watching spoiled children whose parents have cut them off, it’s going to be ugly.
But first, what happened? For the last three years the Swiss National Bank (despite its innocuous name, it’s the central bank of Switzerland) had pegged its currency to the euro such that the franc’s value would not be allowed to rise above 120% of the euro’s value. The SNB did this because, as central banks in all the world’s large economies began to behave irresponsibly, Switzerland was seen by millions of people as an almost unique refuge of sound fiscal policy. As a result, demand for the Swiss franc soared, making Swiss exports uncompetitive and threatening tourism to Switzerland. (Lots of less expensive countries also have alps.)
As recently as December 18, the President of the SNB, Thomas Jordan, stated that the bank would buy euros in unlimited quantities with “the utmost determination” to support the peg. On January 12, 2015, the Vice President of the bank, Jean-Pierre Danthine, reiterated that the franc’s peg to the euro was a “pillar” of Swiss monetary policy. A mere three days later, all this was revealed to be a lie and the SNB abandoned the 120% peg. Instantly, the value of the Swiss franc skyrocketed against the euro – 30% in one day, a simply astonishing bit of volatility for a major currency – with all the consequences cited in my opening paragraph, above, and more.
True, there are technical and historical reasons why the SNB’s action reverberated far beyond Switzerland.(3) When the Soviet Union collapsed, for example, Western European banks rushed into the credit vacuum in Central and Eastern Europe, and many of the loans they made were denominated in Swiss francs. This tactic protected the banks against wild fluctuations in the new countries’ currencies, but it exposed borrowers to possible appreciation of the franc. Imagine a householder waking up in Poland on January 16 and discovering that, in effect, his home mortgage debt had just increased by 30%!(4)
Another problem was that, once currency speculators witnessed Swiss capitulation, they began to ask themselves who the next capitulator might be. The answer was Denmark. Like Switzerland, Denmark is a tiny country(5) with a sufficiently small currency “float” that speculators can have an important impact. Immediately following the Swiss decision, the Danmarks Nationalbank reduced already negative interest rates from -0.05% to -0.2%. Less than a week later, still under pressure from speculators, Denmark cut its interest rate again, this time to -0.35%. And then, just as this post was going to press, a week later the rate was cut a third time, to -0.5%.
We might ask ourselves why an august (well, previously august) institution like the SNB should take such precipitous action, especially in light of its own executives’ recent assurances that it wouldn’t. The SNB’s action not only sent the franc soaring and the Swiss stock market plunging, but it badly damaged the prestige of the bank and trashed confidence in its judgment. As noted above, I believe the same effect will soon happen on a vastly larger scale, as confidence is lost in the Fed, the ECB, the Bank of Japan and the Bank of England.
President Jordan’s initial explanation for the SNB’s action was nonsense – and widely perceived to be nonsense. He claimed that over-valuation of the franc had decreased and therefore the peg was no longer necessary. As the skyrocketing value of the franc post-peg demonstrated, this was rank drivel. The next day, having pulled an all-nighter trying to think up a better explanation, Jordan announced that the real reason they had removed the peg was that it wasn’t tenable in the long term.
This was at least closer to reality. The SNB’s problem was that it had accumulated massive holdings in euros – equal to 80% of Swiss annual GDP – because, in order to support the peg, it had to buy euros constantly to hold down the franc’s value. If, as expected, the ECB launched a major quantitative easing program, that would drive the euro even further down, reducing the value of all those euros the SNB had on its balance sheet.
The scale of euro holdings by the SNB was already extremely controversial in Switzerland, because hardly anyone there trusted the ECB and, therefore, hardly anyone there had confidence in the euro. In fact, a public referendum was held in Switzerland late last year that would have required the bank to sell its euros and buy gold(!). The initiative failed, but it obviously alarmed the SNB.
The volatility following the Swiss action on the euro peg was so extreme that traders characterized it as “volatile volatility,” an amusing phrase that refers to a series of sharp, unexpected moves in major markets like currencies, bonds and stocks that can have life-threatening consequences for financial institutions inured to low vol, and that presages nothing good.
In my next post we’ll move from the Lilliputian precincts of the Swiss National Bank to the Brobdingnagian realm of the ECB, BOJ, and the Fed.
(1) Just as examples, FXCM, an online currency trading house in NYC, said its offshore retail customers lost so much money that it was in breach of its minimum capital requirements. It had to be rescued by Leucadia National. Global Brokers NZ Ltd. In New Zealand failed altogether. Alpari UK a British foreign currency trader, entered insolvency proceedings. (Alpari sponsors the West Ham United soccer team). Although some hedge funds actually made money, having hedged the euro and gone long the franc, most were caught leaning the wrong way, having gotten used to central bankers saving their bacon. Fortress Investment Group’s Macro Fund, for example, dropped 8% on the week. Maybe most remarkable of all, famed emerging markets investor, Marko Dimitrijevic, who grew up in Switzerland, was forced to close his flagship global fund as a result of losses associated with a bet that the Swiss franc would fall.
(2) My firm, Greycourt, put out a brief paper on the subject, available here: http://www.greycourt.com/wp-content/uploads/2015/01/Swiss-Franc-Update.pdf. Greycourt’s paper is a measured analysis of what happened and its implications, while my take in this post is, as usual, an hysterical and heretical view of the same event.
(3) Within Switzerland, the Swiss stock market dropped 9% in one day, and some export-sensitive stocks (Swatch, for example) dropped nearly twice as much.
(4) Almost 40% of Poland’s household loans are denominated in Swiss francs.
(5) Switzerland is more the size of an American state, being slightly smaller than Virginia, while Denmark is more the size of an American city, being slightly smaller than Boston. Denmark is a member of the European Union but doesn’t use the euro, while the Swiss, of course, aren’t members of the Union and also don’t use the euro.
Next up: A Dark Harbinger? (Part 2)
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