To many observers, the Swiss National Bank’s (SNB) unexpected exchange rate action crossed a critical line of pursuing national benefits in spite of international harm.
Disclosure: Author has no holdings affected by the SNB move
The Swiss action thus ramps up the critical examination that began when the European Central Bank (ECB) lowered interest rates to benefit EU exporters (a competitive action). Understandably, other countries countered or considered countering the ECB's move. Now, because of the Swiss shock to the international financial system, coming only days before the ECB makes a key bond-buying decision, the Swiss move has the key elements of a case study – an excellent example for discussing whether or not central banks' current actions are beneficial, ineffective or harmful.
This attitude does not run counter to investor’s “Don’t fight the Fed” mantra. Rather, it separates evaluating economic health from measuring investing well-being. Here is how the viewpoint is changing:
First, central bank actions are no longer viewed as win-win
This realization became more widespread following the European Central Bank's moves to alter the euro's exchange rate so as to make European exporters more competitive. Naturally, that means non-European exporters were disadvantaged. Thus began the broader recognition that central bank’s well-intentioned decisions could produce negative outcomes.
Now comes the Swiss National Bank action and the huge financial effects that even put some firms on the brink of insolvency. There is no way of labeling that move as win-win. In fact, the results were so large that even the Swiss say the magnitude was neither foreseen nor intended. So, add to the lack of win-win the potentially devastating law of "unintended consequences," and the result is a serious concern as to whether central bankers are doing good or doing harm.
Currency exchange graph courtesy of StockCharts.com
As evidence of the change of heart, look at the numerous headlines of The Wall Street Journal’s day-after articles:
- “Swiss Move Roils Global Markets – SNB’s Surprise Scrapping of Euro Cap Triggers Turmoil Among Bonds and Currencies”
- “Swiss Currency Move Shows Risks of Highly Interconnected Financial System”
- “After Defending Cap, Central Bank Chief Scraps It”
- “Europe’s Smaller Central Banks Likely to Cut Rates After Swiss Move – Denmark and Sweden Likely to Lower Rates After Swiss Cut and Before ECB Bond-Buying”
- “Swiss Businesses Fear Franc’s Strength – Surging Franc After SNB’s Decision to Scrap Cap Threatens Exports”
- “ECB Can No Longer Duck the QE Question – Expectations High That ECB Will Start Buying Eurozone Government Bonds”
- “Bankers, Traders Scramble to Regroup After Swiss Move – SNB Says Shock Was Necessary to Avoid Improper Trading”
Even veteran currency traders who have seen it all were shocked.
It was a demonstration of the power that central banks hold over markets but also underscored the costly disruption sudden changes can cause.
And then there is this key article:
“Swiss Shock Tarnishes Central Banks – Decision Reflects Tough Times for Monetary-Policy Makers”
R.I.P. the Swiss National Bank’s exchange-rate policy, 2011-2015—and, potentially, the central bank’s credibility.
The challenges for central banks keep stacking up. Some are grappling with the risk of deflation, like the SNB and ECB. Others face the tricky task of trying to bring interest rates off the floor after years of ultraloose policy, like the Fed and Bank of England. That is against the background of a still-uncertain growth outlook in much of the developed world and financial markets that have been pumped up by central-bank largess.
For investors, the SNB’s reversal raises the risk that central bankers are finding they aren’t as all-powerful as they have been believed to be. Markets have come to rely on central banks to save their bacon. But Thursday’s ructions are likely to have left investors disoriented and potentially nursing large losses that could ripple through markets in unexpected ways.
The New York Times put it in historical perspective here:
“Economic Lessons From Switzerland’s One-Day, 18 Percent Currency Rise”
These are strange and unnerving times in global financial markets, and if Thursday’s jaw-dropping move in the Swiss currency didn’t prove it, nothing will.
It is not every day that the currency of an advanced, economically important country rises by double-digit percentages against the currencies of other such countries within mere hours. But that is what happened to the Swiss franc on Thursday. It is up 18 percent against the euro as of Thursday morning, and at one point was up 39 percent. Currency strategists were searching for any analogue in modern history for a similarly abrupt move in major Western currency and coming up empty.
The Swiss move offers interesting lessons about the oddly precarious state of the global economy….
And Bloomberg put it in academic-statiscal perspective (with Wall Street humor added in) here:
"No One Was Supposed to Lose This Much Money on Swiss Francs"
Goldman Sachs Chief Financial Officer Harvey Schwartz said on this morning's earnings call that this was something like a 20-standard-deviation event, and while the exact number of standard deviations is of course a subjective matter, that's the right ballpark. Over the 12 months ended on Wednesday, the annual volatility -- that is, the annualized standard deviation of daily returns -- of the euro/franc relationship was a bit over 1.7 percent; over the last three months of that period the volatility was less than 1 percent. That converts to a daily standard deviation of something like 0.1 percent. On Thursday, the euro ended down almost 19 percent, or call it 180 standard deviations, depending on what period you use.
An 180-standard-deviation daily move should happen once every ... hmmm let's see, Wikipedia gives up after seven standard deviations, but a 7-standard-deviation move should happen about once every 390 billion days, or about once in a billion years. So this should be much less frequent. Good news I guess, Switzerland won't be un-pegging its currency for at least another billion years, go ahead and set your Swatch by it.
Second, the return of weakening growth and deflation concerns (recession-type issues) imply central bank ineffectiveness or, worse, disruption
Here, central bank logic is questioned. The central bankers’ view is that, if tight money at high rates can stifle economic growth, then loose money at low rates can foster it. However, this multi-year experiment has so far failed to produce the proof. Instead, numerous observers and analysts have shown the abnormal slowness of the recovery from the Great Recession in numerous key areas: employment, wages, consumer spending, business investment and housing.
Central banks have used these lower improvement rates as a sign of economic fragility, supporting the continuation of the easy money policies. However, as we approach the sixth anniversary of the recession’s bottom and birth of central bank actions, the subpar growth trends are showing signs, not of finally improving, but of worsening. Therefore, another conclusion is forming: that the central banks’ actions are interfering with and possibly negating the natural recovery and growth tendencies of a capitalist economy when the price of money (a key capital allocation factor) is market-, not central bank-, determined.
Articles have recently been describing how low rates, a seeming benefit to banks, have actually reduced spreads and, therefore, profitability. Here is the latest: “Biggest Banks Lag Behind as Economy Gains Steam.” [underlining is mine]
More than five years into the economic recovery, the nation’s biggest banks are still on the outside looking in, as their fortunes grow increasingly disconnected from the rest of the country’s.
Once looked to as a proxy for the financial health of American consumers and businesses, banking giants are struggling to boost profits despite safer balance sheets, a boom in global deal making and pockets of loan growth.
Bank of America Corp. and Citigroup Inc. on Thursday posted disappointing results. While bank profits have bounced back from the dark days of the financial crisis in late 2008 and 2009, the latest year can be best viewed as an interruption in the recovery.
Like other big financial firms, Bank of America and Citigroup suffered to varying degrees from slumps in trading and the continued effects of low interest rates.
Third, the growing concern that the unusual financial trends are being caused by the central banks’ policies
This worry started when the large easy money policies began, creating the fear of future inflation and a deteriorating US dollar. After gold peaked and the economic “mega-fears” dissipated, fretting switched to easy money’s supposed investment bubbles.
Then came the recent, significant commodity price declines. Oil is certainly the most discussed, but the same price drops are occurring throughout the commodity world. Most worrisome is the common reason: producers are willingly continuing to produce, in spite of falling prices and rising inventories. Typically, times of excess beget compensating times of underproduction, often with financial distress. Therefore, producers usually take steps to avoid being caught – but not this time.
So, what is the cause for this seeming game of chicken? Is it confidence in a coming growth pickup? Or is it a competitive tactic to take out higher cost producers? Or is it the necessity of keeping revenues flowing and/or workers working? Or is it the availability of easy, cheap financing? Obviously, that last possibility is the product of central banks’ policies, adding to the overall growing concern.
Associated with the commodity price drops is the growing worry about deflation, now being viewed as a possible reason the U.S. Federal Reserve will be reticent to move quickly away from its low interest rate policies. But what if the deflation is a fallout from the policies, themselves?
The bottom line
The Swiss National Bank action that roiled exchange rates, financial markets and the world’s central bankers is a potential case study for judging central banks’ actions and whether they might prolong or worsen economic problems, not solve them. This Swiss case comes at a time when central bankers are being more critically examined.
How will it all fall out? It’s too soon to tell. It is difficult to see the central bankers, of their own volition, backing away from their low rate, easy money policies. That leaves their government overseers having to step in – but then that would mean overriding the banks’ prized independence. Instead, the link between central bank action and undesirable results would likely have to be more obvious for that to happen.
Therefore, central bank maneuvering is probably here to stay. However, compared to the past five years' recovery period, we should expect more volatility as central banks ramp up nationally-focused moves, seeking to gain an improved position for its country.
The major risk, of course, is that, like times in the past, protectionist attitudes could add uncertainty to or, worse, harm international trade and relations. This article shows how the Swiss action can be viewed as a precursor to that undesirable outcome:
Saudi Gazette: "Wars of currencies ... again!"
The tiny country, which is Switzerland, single handedly shock[ed] the financial world, proving once again that a single country with a relevant decision can have a massive impact on the global economy and reminding us once again how intertwined this global economy has become and how extremely interdependent it is.
The Swiss central bank's move was a strong indication that we are in for a new currency war.
