28th August 2014 by The Harried House Hunter
The economic situation at the moment has several features which are inter-twined. We have the flaring up of several flash points of which the most dangerous at the moment appears to be in the Ukraine. Also we have a struggling Euro area economy an example of which has appeared this morning where even one of the current outperformers Spain has declared consumer inflation running in August at an annual rate of -0.5%. In response to this the European Central Bank will unveil its Targeted Long-Term Refinancing Operations (TLTRO) next month and of course it has already dipped one of its toes into the world of negative interest-rates. These are likely if you read the speech given by ECB President Mario Draghi at Jackson Hole last weekend to be opening salvoes in what is looking likely to be a long campaign. One consequence of the ECB’s actions has been a Euro which has drifted lower to around the 1.32 level versus the US Dollar.
What about the Swiss Franc?
We are describing above a scenario where a perceived safe-haven such as the Swiss Franc might start to look even more attractive. After all the Swiss doctrine of neutrality means that they are unlikely to find themselves entangled in the mess which is the state of play in Ukraine. Also the Swiss economy has managed to grow in each of the last seven quarters and as of the end of the first quarter of 2014 was growing at an annual rate of 2%.
Anybody remembering the problems of a few years ago when the Swiss Franc surged? Well recently it has been rising and overnight it has pushed higher again to 1.2066 versus the Euro as I type this. So we have another sign of rising tension which takes us back to troubled days in the past.
What will the Swiss National Bank do?
Let us remind ourselves of its past promises, from just under three years ago on the 6th of September 2011.
The Swiss National Bank (SNB) is therefore aiming for a substantial and sustained weakening of the Swiss franc. With immediate effect, it will no longer tolerate a EUR/CHF exchange rate below the minimum rate of CHF 1.20. The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities.
You may note that the “substantial and sustained weakening” promised by the rhetoric is hardly matched by it being at 1.2066 some three years later! Although to be fair the Swiss Franc did fall to around 1.25 versus the Euro for a bit although this was a time rife with rumours that its minimum bid level would rise to either 1.25 or 1.30 via “further measures”. Perhaps you could argue that markets have decided that such rumours were like the boy who cried wolf, although the environment has also changed as discussed above.
So the SNB will be girding it loins right now just in case it has to intervene again. After the embarrassing episode when markets nudged the rate through 1.20 it developed the habit of beginning its interventions ahead of the 1.20 barrier so do not be surprised if it does this again.
The SNB as a hedge fund
As a result of its sales of the Swiss Franc and purchases of the Euro the SNB has found itself in a position where it had foreign currency investments of 457.2 billion Swiss Franc equivalents as of the end of June. This is a substantial amount and has ballooned the size of its balance sheet which otherwise would be a tenth of what it currently is. In that form it has been compared to a type of Quantitative Easing.
The issue of the SNB as a hedge fund comes from the fact that having so much money has changed the way it invests the reserves. In the past central banks would mostly hold short-dated bonds in the various major currencies (Euros,Dollars,Yen, Sterling etc…) but that has changed.
In 2013, the SNB increased the share of equities in its foreign currency investments from 12% to 16%. It expanded its equity portfolio to cover equities of small-cap companies, as well as equities from advanced economies that had previously not been included.
Personally I think that such a change for a central bank is rather dubious to say the least but it is the current state of play.
In the long term, equity holdings contribute to both a higher potential return and a more balanced risk profile of the assets.
What about the Swiss economy?
The Swiss money supply surged in response to the creation of new Swiss Francs (to be sold) by the SNB and in terms of broad money (M3) peaked at an annual rate of just over 11% in the summer of 2013. In the past the monetary growth surge following the period of foreign exchange interventions would have been inflationary. But not so far this time around as the credit crunch brings us another surprise. If I may make a broad brush sweep then four years of excess monetary growth has led to no inflation at all so far at least. Looking forwards there seems also to be little sign of it on the horizon.
At 0.1%, the inflation forecast for the current year is 0.1 percentage points higher than in March. For 2015 and 2016, the new forecast – of 0.3% for 2015 and 0.9% for 2016 – is 0.1 percentage points lower, in each case, than at the previous monetary policy assessment.
Of course there is a begged question here which is to ask what the level of disinflation would have been in Switzerland if the currency had been allowed to surge?
What about bond yields?
Swiss government bonds have joined in the summer rally of 2014 and of the world’s main economies it has the lowest ten-year benchmark yield at 0.45%. Puts Germany’s 0.9% in perspective (as well as telling us where German yields would be if it kept the Deutchemark) does it not? Also we learn that in government bonds in Switzerland there is in effect no interest or as near as makes no difference. Accordingly are investors speculating on a continuation of disinflation? I was wondering how annuities now work in Germany with its low bond yields only yesterday and the issue is larger in Switzerland. It becomes a currency play which if you think about it is a possible tsunami for the SNB. In an extreme scenario promising “unlimited intervention” would turn out to be none too bright.
What about Eastern Europe?
Obviously there are plenty of fears in eastern Europe right now about possible further Russian expansionism. But for newer readers what I am referring to here is the amount of foreign currency borrowing that took place in thsi region and in particular the Swiss Franc component of it. Just as an example there was a spell where it was estimated to 60% of all borrowing in Hungary was denominated in Swiss Francs. In case you were wondering why back then interest-rates in Swiss Francs were lower and the effect of the “carry trade” as this became called was also to depress the value of the Swiss Franc. So win-win. Until the creidt crunch hit and the Swiss Franc surged and mortgage borrowers saw both their debt and their monthly repayments shoot up.
Different countries have dealt with this problem in different ways as Hungary for example shifted the problem mostly to the (foreign-owned) banks. But a new period of strength for the Swiss Franc would begin to open up a few old wounds and as ever it would happen at a time when the patient was weakest. If we just look at Hungary the exchange rate has moved above 260 Forints to the Swiss Franc so as Glenn Frey put it.
The heat is on, the heat is on, the heat is on
Oh it’s on the street, the heat is on
There is much to consider here and let us start with Switzerland itself. It faces the possibility of being an enormous hedge fund with an attached country and population should the Swiss Franc find more support. So far it has recovered from the credit crunch grown and avoided any inflation from its monetary surge. But as we look wider we see that it has exported disinflation to the Euro area by its currency cap. Of course there are other factors but it is in there too and one day other countries citizens may mull how Switzerland rescued itself at their expense.
But as ever the situation is complicated as some in eastern Europe will be grateful for the efforts of the SNB as otherwise it seems likely that they would have seen their mortgages explode. Is the price of a bailout for them more disinflation in the Euro area? On top of it all there is now the possibility that the “cure” was only temporary and like the Terminator the Swiss Franc is saying “I’m back”.