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Thursday, January 15, 2015

Hawks Ambushed By The SNB. Sigh.

I assume that the Treasury bears would like to take a Mulligan for 2015. Annual outlooks published just a month ago were almost uniformly bearish, But in just two weeks of trading the 30-year bond has rallied more than 30 basis points. To add insult to injury, the latest rally has been fuelled by the normally innocuous Swiss National Bank (SNB). Closer to home, my fairly hawkish "base case scenarios" look like they are morphing into what I saw as the lower probability "crisis and panic" scenario.

The SNB Strikes (Or Capitulates)

It should not come as a surprise that an attempt to fix exchange rates comes apart. (What is it about Europeans and fixed exchange rates?) The SNB was attempting to keep the euro-Swiss Franc exchange rate from strengthening below 1.20 (a lower figure indicates a stronger franc). Theoretically, a central bank has an unlimited capacity to weaken its currency. However, doing so requires it to buy foreign currency assets. In this case, the SNB was forced to buy a lot of euro government bonds. For some reason, this policy was no longer acceptable. The Swiss franc headed to some ridiculous level like 0.75 (although markets had largely seized up and could not provide quotes), but has since recovered to some level that will be out of date before you read this. This appears to have been the largest short-term move in a major currency since the end of the Bretton Woods era.

Since the SNB had a massive short CHF, long EUR position, it just absorbed a capital hefty loss on its foreign exchange reserves. The implication is that some forex-trading entities elsewhere had large capital gains. Unfortunately, that is the net of all positions, and there are probably at least some entities that were completely blown out of the water on this move. The shut down in activity by those entities probably outweighs the benefits received by the winners. (UPDATE: The first failed foreign exchange dealer has been sighted; more may be on the way.)

Further afield, there are supposed to be plenty of borrowers in Eastern Europe who have Swiss franc-denominated mortgages because they were "cheaper". That plan apparently did not work out very well. Banks with those exposures will probably be viewed with suspicion. (Regulators and banks in Europe appear to have a very difficult time understanding how floating exchange rate regimes work.)

A weaker euro versus the franc should benefit euro area exporters at the expense of the Swiss. This should theoretically be something resembling a zero sum event. However, the destruction in activity of Switzerland will probably be larger than any benefit the euro area receives. This is because investment has an accelerator effect that makes behaviour non-linear when a recession hits.

The fall in the euro should help that ailing region. However, the atmosphere of crisis may kill business confidence. Meanwhile a weaker euro offends national sensibilities, and this may undercut the political support of the ailing common currency.

Blowback To The United States

Hawks at the Federal Reserve probably cannot believe this is happening. They want to go out and announce to the world that the Treasury market is wrong, and the rate hike train is starting to build up steam. But in the current market environment, it would take fairly colossal stupidity for a FOMC member to discuss rate hikes. The Fed has several months to allow things to calm down, but there is little sign of that calm developing. We can no longer use the excuse that we are in thin holiday markets (which I used in December),

In my 2015 Outlook, I mentioned briefly the possibility of an "Ultra-Doveish Scenario", the implications of which I summarised in two words: "Buy bonds!". I prefer not to panic and hope that scenario can be avoided, but its probability is rising.

Canada: In Recession Already?

The drumbeat of job losses in Canada has been steady over recent days. The retail sector is shedding capacity, which appears to be a hint about the volume of holiday shopping. I do not follow the data flow closely enough to be confident about this, but it is possible that historians will pin the start of the recession at some date in the immediate past.

Given the large volume of trade across the Canada-United States border, a recession here will not help the Fed Hawks' case.

[Update] Implications For Government Promises

One interesting implication of this move is what it says about government promises. Although the policy was financially sustainable (there was no real cost to the SNB to create francs), it was still abandoned. One could attempt to draw a parallel with other government commitments, such as an inflation target, or even the commitment to not default on its debt.

With regards to a potential sovereign default, I argue that promises to redeem government debt are inherently sustainable, unlike the euro-franc floor (one-sided currency peg). I hope to explain this in further detail in a longer article, probably published next week.

(c) Brian Romanchuk 2015


  1. In a previous comment, I claimed that unbalanced trade must always result in large foreign currency (or debt) holdings by one nation, citing Japan's large stock of US Bonds. It seems like the SNB has been accumulating large amounts of EURO Bonds and became alarmed about the potential value of those bonds.

    (What follows is an over-simplification. The SNB was using the EURO as a reference point.)

    Apparently Swiss watches (for example) were selling well in EURO land and the SNB was facilitating the trade by converting currencies and buying EURO bonds.

    Going forward, it seems like the Swiss can still sell watches for EUROs but now it will be up to the watchmaker (or his employees) to do the currency conversion. We can expect a change in trade patterns.

  2. Floating rate currencies will move to eliminate a trade imbalance in a pure model - where nobody wants to hold foreign assets - because exports are impossible unless everybody also gets the currency they want as part of the trade. Both the end to end real transactions and the end to end financing transactions have to be in place for the deal to happen. Banks make money ensuring the financing chain is in place (think letters of credit, etc).

    So now that the SNB has taken its ball home the system will run out of CHF liquidity unless private sector entities increase the amount of Euro financial assets they are holding. The result is a rise in the CHF until export deals start to fail or Swiss currency area entities start holding more Euros.

    All export surpluses are maintained by a forced saving pattern amongst entities in the export currency area. Those forced savings tend to move towards the central bank as entities lay off the foreign asset risk.

    1. In response to Neil & Roger's comment above: I agree.

      I think the adjustment towards a new "equilibrium" would come via non-Swiss no longer wanting to hold Swiss francs. Unfortunately for the Swiss, I do not think real economy trade flows nor flows by the Swiss themselves are enough to overcome the wave of foreigners who want to get out of EUR into CHF.

      Capital controls might do the trick, but it is difficult for a country which has financial services as a major "export" to justify putting into place capital controls.

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