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The Swiss National Bank’s decision to remove the three-year cap preventing the Swiss franc from appreciating against the euro caused turmoil in the foreign exchange market. Photo: Bloomberg
The Swiss National Bank’s decision to remove the three-year cap preventing the Swiss franc from appreciating against the euro caused turmoil in the foreign exchange market. Photo: Bloomberg

Lessons from the Swiss franc explosion

SNB's move has shown that a consistent global monetary policy stance is now clearly in the past

The Swiss National Bank (SNB) threw a dynamite stick into the placid waters of global financial markets on 15 January. Its decision to remove the three-year cap preventing the Swiss franc from appreciating against the euro caused turmoil in the foreign exchange market, with the franc immediately appreciating 40% against the euro and 30% against the US dollar. Reverberations were felt across markets with large moves in European stocks and bonds as frantic investors tried to interpret the decision and reposition their portfolios. SNB’s blast caused quite a few casualties. Foreign exchange broker Alpari, for example, was rendered insolvent and Everest Capital announced the closure of its $830 million flagship fund. Large losses are also being reported at other hedge funds, brokers and banks.

The shock from SNB’s decision is not just destined to become part of market folklore; it also holds some important lessons for investors. The unprecedented and perhaps ill-judged central bank interventions in the aftermath of the financial crisis have caused volatility to decline and asset prices to rise. As a result, complacency among investors has been creeping up along with the trust in central bank protection of financial markets. The Greenspan “put" has gone global. However, as this column has frequently argued (see Contemplating the Minsky Moment), this situation is untenable. Investors would be wise to heed the dangers that lurk beneath the calm surface of the financial markets.

First, the risk of large, violent moves has been increasing for quite a while. The great moderation in financial market volatility has led to unintended consequences that undermine this very stability. Low interest rates, quantitative easing (QE) and other monetary policies aimed at reviving investment and growth have also reduced the cost of funds for investors along with an expected yield on investment. This has led to the usual hunt for yield with record flows into riskier assets and emerging markets leading to asset prices that may not be fully reflective of underlying risk. Even Janet Yellen, the US Federal Reserve (Fed) chair and proponent of the current easy-monetary policy, expressed unease last year with the level of risk-taking in some markets.

Risk-taking has been accompanied by a high level of investor leverage and crowded trades where a number of investors have the same position in an asset. Therefore, when prices turn, they tend to turn quickly and violently. However, mollifying comments by central bankers every time markets take a tumble have cemented the belief of participants in the central bank “put", thereby encouraging even greater risk-taking. In the case of the franc, several market participants had taken short positions against prevailing economic fundamentals secure in their assumption that SNB would defend the cap. It proved a costly one-way bet.

This ever-greater risk-taking has led to the classic reflexive upward move across assets, which, as history has shown, does not sustain forever. Either the mismatch between investor expectations and fundamentals is exposed akin to what occurred in sub-prime mortgages in 2007 or the central bank “put" is suddenly removed as in the case of the Swiss franc. The “moment of realization" coupled with crowded trades and investor leverage leads to violent moves and large losses as everyone rushes to exit at the same time.

Second, your portfolio is not the primary concern of central banks. The SNB decision shows the misplaced importance attached by market participants to central banks’ concern for the financial markets. Risk-taking has been boosted by this assumption that central banks will do right by markets and give adequate warning of any policy changes. SNB not only surprised markets by its sudden removal of the cap, but also went back on its statement made only a month earlier in December when it reaffirmed “its commitment to the minimum exchange rate of CHF 1.20 per euro, and…to enforce it with the utmost determination".

The main concern of central banks is the real economy, with financial markets merely a means to achieve ends (mostly through the wealth effect, which holds that increasing asset prices increase wealth and lead to higher spending providing a boost to the economy). Post-crisis monetary policy targeted asset prices to revive the real economy. As the danger has passed and growth shows signs of a revival, monetary policy decisions may not be as favourable for markets. Both the original and the current SNB decisions were made oblivious to the impact on markets. Similarly, the Fed’s QE halt was based on inflation and unemployment data. The facts have changed and investors need to change their mindset.

Third, policy is likely to become more uncertain as economies diverge in their growth, employment and inflation trajectories. Moreover, one country’s monetary policy may impact others. This is underscored by SNB’s volte face, which it partly attributed to divergences between the monetary policies of the major currency areas.

Moreover, political risks will add to uncertainty as the stark contrast between rallying markets and a moribund and lopsided recovery with an increasing wealth gap fuels anger. While most equity markets are above their pre-crisis highs, unemployment is yet to fall to pre-crisis levels in developed countries. Populist protest parties are gaining ground in the West, hampering decisive action on structural issues and fiscal policy. This is most visible within the euro zone, where several anti-euro parties have gained prominence in national politics. These trends are increasing idiosyncratic risks that the investors face.

The SNB action has shown that a consistent global monetary policy stance, which supported the broad post-crisis rally in global risk assets, is now clearly in the past. Even before 15 January, waves had started forming in hitherto calm markets as seen by the precipitous drop in commodities (oil, copper, etc.) and their volatility-inducing impact on other markets. Prudence dictates investors stay close to shore in low-risk assets that they understand. For example, putting money in Eurostoxx while sitting in Mumbai purely because your wealth manager thinks it’s a great play on the European recovery and has delivered in excess of 15% since the euro-crisis abated in mid-2012 may wreck your portfolio. A 40% move such as the one unleashed the instant after SNB’s announcement on 15 January can wipe out more than two years of annual 15% returns.

What is the Swiss franc-euro cap?

SNB’s decision to impose a cap on the franc was announced on 6 September 2011. This was done when the European sovereign debt crisis was in full swing and investors were pouring money into the franc and other safe havens (incidentally, gold prices hit an all-time-high of $1,921/oz. on the same day). To curb the deflationary effect of currency appreciation and the loss of export competitiveness, SNB imposed the cap of 1.2 francs per euro, expressing its commitment to buy “unlimited quantities" of foreign currency to defend it. Although effective, defending the cap has led to SNB owning about half-a-trillion dollars of foreign assets (approximately 75% of the Swiss GDP).

Shashank Khare is an investment professional and writer. After studying engineering at IIT-D and business administration at IIM-A, he entered the world of credit derivatives before CDS became a four-letter word. Having successfully batted through the crises, he now indulges his passion for economics, finance and policy.

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