The First Black Swan of the Year

Why the change of heart?

The currency peg was seen as the cornerstone of Swiss economic policy, and the SNB’s recent announcements gave no hint of the new and abrupt reversal. The SNB used the recent fall in the value of the Swiss franc against the US dollar as a justification for its decision, but the real reasons are many and varied:

• The bank had accumulated foreign currency reserves of SFr 500 billion, creating potential problems in future when this position would inevitably have to be unwound.
• The monetary base soared to around 60% of GDP as Swiss francs were printed and exchanged for euros. This materially increased the risk of inflation.
• Funds flowed into the Swiss franc as foreign investors looked to buy while it was artificially cheap. This created distortions in the economy, including booming property prices and negative interest rates/bond yields.
• The final blow was probably the prospect of imminent Eurozone Quantitative Easing, which would create a vast pool of fresh euro funds and potentially put further downward pressure on the euro.

What are the results?

The result of the SNB’s decision has been a sharp appreciation of the Swiss franc against most currencies, ultimately of around 20%. This has a number of implications:

• The SNB has lost around SFr 50 billion from the devaluation of the foreign exchange reserves that it had accumulated by pegging the Swiss franc. The bank has reduced the ‘interest rate’ on sight deposits by a further 0.05% to -0.75%, and Swiss ten year sovereign bond yields have also turned negative for the first time. Swiss-based businesses now face a significant currency headwind in an economy that is very open, and therefore heavily reliant upon exports.
• A long Swiss franc position was a consensus trade, given the low cost of carry that it involved and the perceived ‘safety’ provided by the SNB. A number of investors, investment banks and hedge funds will now be nursing material losses. For example, currency broker FXCM required a US$ 300 million capital injection to cover potential client losses. As Swiss franc mortgages are popular, especially in Eastern Europe, borrowers have also been exposed to a significant increase in repayment costs when measured in local currencies.

In the short term the Swiss franc is likely to remain strong, reflecting the unwinding of short positions. However, in the longer term the Swiss franc is expected to stabilise above par relative to the euro – a result of the SNB’s loss of credibility, negative deposit/bond yields and a switch out of Swiss equities as their prospects are downgraded.

Our commentary

The ending of the Swiss franc peg is a symptom of the deflationary forces currently impacting global markets, rather than a contributor towards them. We are also witnessing yet another round of the currency war taking place between the major economic blocks as they race each other lower to boost domestic growth at the expense of their international rivals.

In a number of respects this is a very unusual event. In recent times it has been rare for developed economies to use external currency pegs – and when these pegs do finally break down, it is far more common for a currency to depreciate rather than appreciate.

Sharp, unexpected market movements are now becoming increasingly common, as the recent halving of the price of oil illustrates. This has increased the risk profile for investors, which has in turn been reflected in a 7.5% increase in the price of gold so far this January.