The Swiss Mess

Global volatility shifted into overdrive Thursday following a surprise decision by the Swiss National Bank (SNB) to scrap its minimum exchange rate. The development led to massive moves in foreign exchange markets and European equities, helped by speculation that the SNB move may be a harbinger of the long awaited, much rumored, often delayed round of stimulus in the euro zone.

The action in U.S. markets was horrible, but what’s new? After traipsing through all of 2014 without four straight down days, this year has already witnessed two streaks of five down days. The lack of coordinated bids in the major indexes takes your breath away. Where are the buyers?

Although the move by the Swiss central bankers may seem remote and unimportant to U.S. investors, nothing could be farther from the case. Understand that Swiss bankers are considered the gold standard of probity and good faith. The fact that these bankers pulled such a stunning move off without a prior hint is nothing short of mind-blowing, and has dealt a serious blow to the credibility of central bankers everywhere.

We always say that this is the central bankers’ market. The Federal Reserve has called the tune since the start of quantitative easing, or “extraordinary measures,” in late 2008, and its efforts have been synched up with the European Central Bank, Bank of Japan and Bank of England, as well as the smaller central banks worldwide. When all the central banks walked hand in hand in solidarity, the global financial system drew itself up out of the muck of the credit crisis and reestablished dignity, pride, a sense of joint purpose, forward progress, and currency peace.

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But now we see the central banks going every which way as the solid wall of defense against an “every country for itself” mentality breaks down. The Federal Reserve has halted quantitative easing, the Japanese are wavering, the euro zone is playing peekaboo, the Indian bank issued a surprise rate cut, the Russians are in shambles and now Swiss — the Swiss, of all people! — have broken ranks.

Swiss banks had been considered a safe haven for European capital that feared a blowup of the euro. To keep too many people from moving money there, the Swiss set a ceiling for the exchange rate between their franc and the euro. That protected Swiss industries, but required a massive amount of purchases of financial assets to keep it going.

The Swiss finally decided last week that it could not go on with that plan forever, so they launched this blitzkrieg. It’s easy to guess that they did this in anticipation that the ECB would launch quantitative easing later this month, but it almost doesn’t matter. Fearing a currency war, they launched their monetary missiles first.

The central bankers may have thought that they could do this without making waves, but frankly these are mostly academics and do not always understand the real world. Hundreds of billions of francs of bets were on that depended on a mostly flat Swiss franc, and anyone who was short the currency was blown up on Thursday.

Anyone who was short the Swiss franc got blown up last week.

These kinds of currency blow-ups happen about once a decade, and have many wide-ranging effects as currency dealers, brokers, hedge funds and others suffer gigantic losses that will never be recovered. This in turn leads to lower confidence and lower risk taking.

Don’t forget too that lots of Eastern European consumer and commercial loans are pegged to the Swiss franc, as we learned in the 2008 credit crisis, and those all became instantly harder to pay back. Hope you don’t have a mortgage in Poland or Romania.

Going forward, the analysts at Bespoke Investment Group said it seems likely that the SNB won’t entirely abandon its management of the currency. Rather than pegging to the euro alone, it might adopt a wider basket of currencies as a reference.

I contacted our old friend Satyajit Das in Australia for his take. He was traveling somewhere without phone access but did send me a Citi report that had some useful insights. The Citi analyst asked rhetorically, “Is the strategy to drop peg forever or get the market short and restore peg?” The answer was: “This is a tricky question. There were a lot of lazy EUR/CHF longs and it was difficult to put on short EUR/CHF positions through options, so there was little likelihood that investors were positioned for this. The SNB may want to create a two-way market by raising the possibility that a peg would be restored. Unless they outright say ‘never, never’ which would mean ‘probably not immediately’ they may want that kind of speculation to be in place, and leave open the possibility of acting.”

In other words, be prepared for the Swiss to potentially backpedal on the policy, which would itself again erode confidence. What a mess.

Best wishes,

Jon Markman