“Whoever controls the volume of money in any country is absolute master of all industry and commerce.” - James A. Garfield, President of the United States
Last Thursday the Swiss National Bank (SNB) surprised the market by announcing that it would no longer peg the value of the Swiss Franc to the Euro and would simultaneously drop the interest rate on short-term deposits at the SNB to negative 0.75%. The news sent the Swiss Franc soaring against the Euro while the Swiss stock market cratered. In the world of central banking, slow and predictable is the norm which is why the SNB’s surprise announcement created massive price swings in the Swiss currency and stock markets. In this week’s Insight we will look at reasons why the SNB pegged the Franc in the first place, why it may have ended the peg so abruptly and what it all means for our US-based clients.
Switzerland has long been known as a bastion of financial security due to their prolific banking system and disciplined policy makers. Because of this reputation, the Franc began to appreciate rapidly against the Euro back in 2010 and 2011 during the European sovereign debt crisis. During this period of time there was speculation that the European Union might dissolve and the Euro abandoned due to the economic problems of several EU countries. Based on the fear of a break up, European investors were moving their money out of the EU and into Swiss bank accounts. In doing so, they had to sell Euros and buy Swiss Francs which puts upward pressure on the exchange rate (Swiss Franc appreciation versus the Euro).
From the beginning of 2010 through the middle of 2011, the Franc appreciated close to 40% against the Euro. With the Swiss economy being highly dependent on exports which account for 70% of Swiss GDP, and Europe being Switzerland’s largest trading partner, the 40% rise in the value of the Franc versus the Euro meant that Swiss goods became much more expensive for its largest customer base. In response to this potential problem, the SNB decided to peg the value of their currency to 1.2 Francs per Euro, which devalued the Swiss Franc by about 8% overnight.
The devaluation of the Franc worked as the Swiss economy grew and the Swiss stock market became one of the best performing markets in Europe. The price of Swiss goods stabilized for their major trading partner (Europe) and Switzerland became a slightly more affordable place to live. One way to quantify this is by looking at The Big Mac Index which was developed by The Economist as a way to compare the cost of a common good (Big Macs) in different countries around the world to show the over/under valuation of currencies relative to each other. In the middle of 2011, a Big Mac in Switzerland was $8.06 versus $4.87 in Germany $4.07 in the US and $3.89 in the UK (all values in USD equivalent). As of the most recent update to the index back in July of last year, the cost of a Big Mac in Switzerland had dropped to $6.83 (15.3% decrease) versus a rise to $4.94 in Germany (1.4% increase), $4.80 in the US (17.9% increase), and $4.93 in the UK (26.7% increase).
In order to override the free market and artificially devalue the Franc, the SNB committed to selling Francs and buying Euros. Given the fact the SNB has the power to “control the volume” of Francs, this became of form of quantitative easing where Francs were created ex-nihilo and sold into the market to buy Euros. The result was a vast expansion of the SNB’s balance sheet which ballooned to 86% of the Swiss GDP. To put this in perspective, even after all the QE campaigns here in the US, the Federal Reserve’s balance sheet is about 27% the size of US GDP. The size of the SNB’s balance sheet did not sit well with the fairly conservative Swiss electorate. In addition, rumors (the common pre-announcement tool most central banks like to use) have recently been circulating that the European Central Bank (ECB) is planning on launching their own version of quantitative easing. Any QE program by the much larger ECB would mean the SNB would be forced into buying an even larger amount of Euros to defend their 1.20 peg. The combination of the forthcoming QE and the negative sentiment surrounding the SNB’s balance sheet was enough for the SNB to abandon their peg in the same dramatic fashion they announced it.
The market’s reaction to the surprise announcement was radical with the Swiss Franc appreciating 40% against the Euro in a matter of minutes before settling in to a 19% gain by the close. The Swiss stock market had an equally violent reaction but in the opposite direction as it sold off by about 15% over the course to two days as investors anticipated the stronger Franc being a major headwind for the export driven economy. In fact, the Swiss stock market can claim the unfortunate “honor” of making both a 52 week high (Tuesday) and low (Friday) in the same week.
So what does all this mean for US-based investors and our clients? The obvious ramification is that Swiss goods and services (watches, chocolates, vacation rentals, etc.) will be more expensive for everyone, but this impact is minor for most of us. The more important takeaway is to understand the power a central bank has over its own economy. By expanding its balance sheet and artificially suppressing the value of its currency, the SNB was able to manufacture economic and stock market growth. All that came to a rather abrupt end once the SNB decided its current path was unsustainable. Now Swiss business owners will find it increasingly harder to sell their goods and services to other countries. With negative interest rates going out 10 years on Swiss bonds, Switzerland could likely be headed for Japanese style deflation at a point in time when their central bank has just “tapped out” on easing monetary policy. Since the Financial Crisis hit back in 2008, easy monetary policy in the form of QE has been the “free lunch” recipe for success. But as the SNB just showed us, once free lunch monetary policies become unsustainable, central banks and economies as a whole may find themselves stuck between a rock and a hard place.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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