Currency Wars and Other Lessons of the Shock Swiss Rate Move

Just when you thought this might finally be the year of rate normalization and a return to a more traditional financial landscape, the bizarro world of unconventional monetary policy got much more, well, bizarro.

Swiss National Bank Sets Rates

Thomas Jordan, president of the Swiss National Bank (SNB), speaks during the central bank’s rates announcement news conference in Bern, Switzerland, on Thursday, June 19, 2014. The Swiss National Bank pledged to keep defending its ceiling on the franc as the European Central Bank’s stimulus campaign for the euro region sustains pressure on the haven currency. Photographer: Philipp Schmidli/Bloomberg *** Local Caption *** Thomas Jordan

Philipp Schmidli/Bloomberg

Just when you thought this might finally be the year of rate normalization and a return to a more traditional financial landscape, the bizarro world of unconventional monetary policy got much more, well, bizarro.

Just when you thought the Federal Reserve, the European Central Bank and the Bank of Japan had the market’s back, the Swiss National Bank put a knife in many traders’ backs, sparking a surge in volatility and underscoring the deflationary risks that stalk the global economy.

How else to describe Thursday’s stunning about–face by the SNB? The central bank has long prided itself on being as transparent and predictable as a Swiss timepiece. At the height of the euro debt crisis in September 2011, it announced a ceiling for the Swiss franc, at 1.20 to the euro, to prevent an influx of jittery international capital from driving up the franc and hammering Swiss competitiveness. After Mario Draghi last month signaled that the ECB was getting close to launching a big bond-buying program that could weaken the euro, SNB Chairman Thomas Jordan introduced negative interest rates to deter a fresh influx of international funds and said the central bank would defend the 1.20 ceiling “with the utmost determination. If necessary, we are prepared to buy foreign currency in unlimited quantities for this purpose.”

Rarely has such determination caved so swiftly and thoroughly. Within minutes of Thursday’s announcement the franc soared nearly 30 percent before settling at around 95 euro cents, a gain of more than 14 percent. The Swiss stock market plunged nearly 9 percent to adjust for the sudden blow to Swiss corporate competitiveness. “Words fail me,” Swatch Chief Executive Officer Nick Hayek was quoted as telling Bloomberg. “Today’s SNB action is a tsunami; for the export industry and for tourism, and finally for the entire country.”

Consider that an understatement. The consequences of Thursday’s move will extend far beyond Swiss borders.

First, it suggests that Draghi’s ECB will not disappoint next Thursday when the governing council meets to decide whether to embark on quantitative easing. The ECB has been dithering on policy since Draghi’s “whatever it takes” speech in London in 2012; it began seriously mulling QE last summer; it got an effective green light yesterday (January 14) from the European Court of Justice, which ruled in response to a German challenge that bond purchases were a legitimate ECB tool. It’s now put up or shut up time for Draghi. The market is anticipating the central bank will announce a €500 billion bond purchasing program. Anything less would be a major disappointment. Jordan’s move suggests the Swiss are expecting a big move and don’t have the stomach for the massive intervention it would take to defend the exchange rate (the SNB has bought some $160 billion since 2011).

Second, if you thought currency wars was yesterday’s story, think again. This time, the war is taking place not between the U.S. and emerging markets countries but within the heart of the G-7 itself. An ECB QE program will put downward pressure on bond yields, but with Germany’s benchmark 10-year Bund now yielding just 0.50 percent, there’s not a great deal further they can fall. The euro area economy does not suffer from high interest rates. Pushing interest rates a tad lower will do little to resolve the bloc’s deep-seated economic and political problems. But letting the euro drop should give a boost to European exports. For Janet Yellen and her colleagues at the Fed, already worried that the dollar’s 16 percent rise against the euro and the yen over the past six months might sap the strength of the U.S. recovery, this is not good news.

Third, interest rates will stay low for longer, or fall further, just about everywhere. Make no mistake, the Swiss move strengthens the deflationary forces that are gripping the world economy. In its bid to deter speculative inflows of capital, the SNB is lowering its policy rate on large sight deposits to negative 0.75 percent. Russian oligarchs fleeing Putin, dictators and drug-runners looking for a safe place to stash their gains, and hedge fund barons who think the Swiss franc will protect them from financial Armageddon, will now have to pay for that privilege. Yields are at record lows across Europe — Bund yields are negative out to five years; 10-year JGBs stand at 0.24 percent; and yields on 10-year U.S. Treasuries have fallen by half a point since late November, to just 1.80 percent. Remember all those forecasts about how rates would head to 3 percent plus roiling markets? I thought not. As David Kotok, chairman and CIO of Cumberland Advisors, puts it, “For the U.S. to have another major, reliable, sovereign nation trading near zero on its 10-year government bond only puts more downward pressure on global interest rates.”

Fourth, volatility is going higher. Now this may seem counterintuitive in light of the above note about rates, but just take a look at today’s price action. With absolutely no warning, and in blatant contradiction to its repeatedly stated policies, the SNB just repriced a $685 billion economy — and untold billions more in financial assets — by 15 percent. Any investor, and there are plenty, who was borrowing Swiss francs to fund risk positions because he or she believed 1.20 was sacrosanct just had a rude awakening. Central banks and other policymakers continue to exert huge influence over markets, and their actions aren’t entirely predictable. Before today, investors were worried mainly about the risk of destabilizing moves from Vladimir Putin or Nicolas Maduro or the Saudi oil minister or perhaps Al Qaeda in the Arabian Peninsula. No one saw it coming from Thomas Jordan.

I’d still bet my bottom dollar that the Fed will raise interest rates later this year. Yellen is worried about the buildup of risks promoted by unconventional policies and is itching to get off the zero bound. It’s also a fair bet that the deflationary forces cited here will reduce the pace and extent of U.S. rate hikes. That may provide little comfort to investors. In recent weeks, the idea had begun to take hold that markets were well prepared for the Fed to tighten and that the once-again mighty U.S. economy would keep powering ahead. Thursday’s events suggests a bit more humility is in order.

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