On 15 January 2015, the Governing Board of the Swiss National Bank (SNB) unexpectedly exited its minimum exchange rate regime, which it had adopted back in September 2011 when it was fighting sharp appreciation of the Swiss franc in the midst of the eurozone sovereign debt crisis. Under this regime, the SNB promised to accommodate market demand for the Swiss franc at a minimum price of CHF 1.20 per euro by printing unlimited quantities of Swiss franc. Since the introduction of its minimum exchange rate regime, the SNB’s balance sheet has increased to CHF 525 billion by the end of November 2014, representing a staggering approximately 86% of the country’s GDP. As a comparison, the size of balance sheets of other major developed market central banks is a lot smaller; with only the Bank of Japan anywhere close (see Figure 1).
The Swiss franc closed up almost 20% after briefly reaching highs of 30% immediately after the announcement (Bloomberg, as of 15 January 2015). The actions of the SNB came as a shock to financial markets. Not only did the SNB catch the market completely unprepared, but it had been reassuring markets of the longevity of its minimum exchange rate policy as recently as 12 January in an interview with SNB Vice-Chairman of the Governing Board Jean-Pierre Danthine (Reuters, as of 12 January 2015). The size of the intra-day move in the Swiss franc may likely dwarf any previous one-day move in a developed market currency going back to ‒ and including ‒ the break of currency pegs against gold under the Bretton Woods system in the 1970s!
This naturally begs the question, why was the SNB shifting its policy?
Officially, the SNB claimed the minimum exchange rate policy was temporary given exceptional circumstances, protecting the Swiss economy from a rapidly appreciating currency. Given the Swiss franc depreciation against the U.S. dollar, maintaining the floor with the euro was no longer justified. The price action on 15 January tells us that financial markets did not buy this narrative. The surprising departure from a long-held policy rather suggests a change in the SNB’s cost-benefit calculus of continuing with its current policy. There could be several reasons behind this shift.
First, it is possible that the SNB expected the shift in policy to have a much lower impact on the Swiss franc’s exchange rate than it did. According to recent comments from Mr. Danthine, the SNB sees the fair value of the Swiss franc in the range of CHF1.28-CHF1.30 per euro. The SNB may have believed that markets will be unlikely to overshoot fair value estimates by much. It may also have hoped that, by lowering interest rates deep into negative territory, it would limit appreciation pressure on the currency.
Second, the SNB may have decided to change the policy in the face of an increasing likelihood of a European Central Bank (ECB) quantitative easing (QE) announcement in its policy meeting on 22 January 2015 . Given the ongoing relentless fall in eurozone inflation, market speculation has been building that the ECB will be forced in January to announce QE, involving large scale purchases of sovereign bonds. The SNB may have concluded that the financial risks of defending its minimum exchange rate policy were likely to be too high in the event of potential action by the ECB, and decided to get out of the way of the flood of euros that is likely to be printed.
And third, and somewhat related to the first two points, the SNB may have estimated that the financial risks involved in a further substantial increase of its balance sheet defending the minimum exchange rate regime outweighed the pain of adjustment that Switzerland’s economy may have to go through in the event of further currency appreciation. Even without the looming ECB QE announcement, Switzerland has been struggling to recycle its persistent and large current account surplus. As the size of the SNB’s balance sheet reached lofty levels, the cost/benefit of defending the current regime in order to recycle the current account surplus alone could have been seen to be diminishing.
Of course, there are other potential explanations besides these. What is clear is that almost no one in financial markets expected such a sudden shift in SNB policy. The SNB could have prepared the financial markets better by explaining the likely evolution of its policy framework before making such a radical change. In addition, the SNB had various options available to them as intermediate steps in its transition from a minimum exchange rate regime back to a freely floating currency. For example, they could have lowered interest rates, reduced the exemption threshold on remuneration of sight deposits or even moved to a managed float against a currency basket.
What does this mean for financial markets?
We expect that the abandonment of the exchange rate floor will be a big negative shock to the Swiss economy, which we think will likely sink deeper into a deflationary spiral. Yields on 10-year Swiss bonds traded down, below 0% on 15 January 2015, and appear likely to continue to fall deeper into negative territory. The Swiss stock market closed down almost 9% on the day (Bloomberg, as of 15 January 2015), suggesting market expectations of sharp hits to profitability and growth prospects of Swiss companies.
Given the size of the move in Swiss franc on 15 January, we believe that there is a chance that we could see casualties in financial markets, particularly within leveraged investors. There are no obvious candidates; but given the challenging liquidity environment, we think there is a risk that losses emanating from Swiss franc positions may force an uncontrolled unwinding of other risk positions in the hedge fund community.
However, it is not all bleak. Some believe that the timing of the SNB’s action, less than one week ahead of the 22 January ECB meeting, suggests that the ECB may be about to announce a significant and credible asset purchase programme. Even prior to the SNB’s action, we believed this to be the case. A forceful ECB QE programme has the potential to be very positive for risk sentiment in Europe, and indeed across the globe. We believe it could drive yields on bonds of European peripheral countries lower, boost European equity markets, particularly bank stocks, and increase the downside pressure on the euro.
The SNB cut its policy rate deep into negative territory. This will be something that will be watched with interest across central bank and financial market communities. Central banks have long feared cutting interest rates deep into negative territory for fear of unintended consequences. Banks may struggle to pass on negative rates to depositors, while at the same time finding it hard to not pass the rate cuts on to borrowers. Many also worry that deeply negative interest rates may incentivise individuals and companies to hoard cash outside of the banking system, raising a dual challenge of a hit to the banking system’s deposit base and net interest margins and a collapse in the velocity of money. Global central banks will be looking closely at the impact of negative interest rates on the Swiss banking and monetary system.
Negative interest rates may also challenge a long-held investor belief that zero interest rates serve as a de facto lower bound to yields. As yields on short-dated bonds have fallen close to or even below zero in Japan and many countries in Europe, investors have sought protection in bonds with longer maturities or by moving their investments into other countries with higher interest rates. With policy rates deeply negative in Switzerland, yields on even longer maturity bonds have fallen close to or below zero. Market participants will look closely at developments in Swiss bond markets and interest rates as a possible roadmap of what might happen in other countries if more central banks were to go down the path of negative policy rates.
Apart from the likely impact on economies and asset prices, this episode will also serve as an important lesson to investors on longevity and effectiveness of unconventional monetary policies. The sudden abandoning of an exchange rate regime that was supposed to be protected by the SNB (one of the G7 central banks that are at the centre of global monetary policy making) with “utmost determination” is a reminder to investors to be more cautious when it comes to risks surrounding an exit from unconventional monetary policies. A lot can go wrong, ranging from central bank communication, timing and sequencing of exit strategies and market reaction to any or all of them. SNB or foreign exchange policies are hardly alone in that respect. Arguably, what is now commonly known as “Taper Tantrum” was essentially the market’s reaction to the mere possibility of the U.S. Federal Reserve beginning to exit its unconventional monetary policy.
Dr. Otmar Emminger, German Bundesbank president from 1977 to 1979, once described that central banking in a small, open safe haven economy is like “being in a boat – or a bed – with an elephant” (as quoted in Barry Eichengreen’s “Exorbitant Privilege”, 2012). He was describing Germany and the U.S. during a period of destabilising capital flows. The analogy applies to Switzerland and the eurozone. The elephant itself is unlikely to be aware of the existence, let alone the discomfort of the smaller creature.
Despite the dramatic appreciation of the Swiss franc in the wake of the SNB’s action on 15 January, the jury is out on whether this will turn out to be a very costly policy mistake, or not. It is possible that initial market reaction has caused an overshoot of the currency, and once investors cut loss making positions and the impact of -0.75% policy rates sinks in, the Swiss franc might find its way back closer to fair value. We believe that investors, central banks and policymakers will be well advised to study the effects of the SNB’s unexpected policy action.