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Friday, January 16, 2015

What Does The Swiss National Bank Know That No One Else Does?

What Does The Swiss National Bank Know That No One Else Does?

After  December’s Rouble rout I thought it would be some time before we experienced such a surprising and sharp move in the foreign exchange markets. Yet yesterday the Swiss National Bank (SNB) unleashed the largest shock markets have seen in some time—a “tsunami” as the Swatch CEO Nick Hayek put it. The Swiss Franc (CHF) appreciated by 39% after the SNB removed its exchange rate floor of 1.20 on the EURCHF. At the end of trading it was still 16% up and is now jostling around parity.
People are still picking through the rubble of yesterday’s events and stories are now surfacing of numerous FX brokers/dealers having their capital wiped out. I suspect this will continue for some time to come. But I wanted to focus on the motivations behind the decision. It is rare that a large central bank unveils a complete surprise – not just in the sense that it had not communicated the move but that there was no significant market pressure or indicators for a move.
Why did the SNB decide to remove its exchange rate floor?
I’ve yet to hear a particularly good or convincing answer to this. Yes, of course the SNB’s own explanation was incredibly lacking and clearly was hiding other reasons (they suggested in vague terms that the economy no longer warranted such FX controls). And yes of course this is all to do with the ECB’s Quantitative Easing. But why now? Furthermore, what changed in the past few days – the SNB Vice Chairman Jean-Pierre Danthine said just a couple of days ago that the SNB was committed to defending the EURCHF floor.
I think there are a number of contributing factors which motivated the move:

  • The ECB is set to unleash some version of QE next Thursday. This would likely see a huge influx of liquidity into the Swiss system as investors search for quality assets (in short supply now). This would have involved the SNB purchasing hundreds of billions more in euros and expanding its already huge balance sheet beyond the 74% of GDP it is now (around CHF 500bn). While this may have been technically possible the SNB balked at the proposition.
  • If the SNB had not dropped its EURCHF floor it would have become even more intertwined with ECB policy which is likely to become increasingly divergent with the desires of the SNB (as well as the US). As such, it saw an opportunity to get out before it becomes just another ship caught on the wave of ECB QE.
  • Linked to this is the idea that the SNB was concerned about its potential exit policy. As yesterday demonstrated, as soon as the floor is removed the SNB will take a huge loss due to the massive appreciation of the CHF and the depreciation of its FX reserves. The larger the reserves get, the larger the potential loss gets.
  • Again, in theory this is a loss which the SNB could manage. Surely, it can just print more francs. Central banks can even survive with negative equity as long as they continue to have their backing of their government and the ability to print their own currency. As such the move seems unlikely to be motivated on purely technical issues.
  • This suggests the SNB made a judgement call, that such potential losses would be a huge dent to its credibility and possibly politically untenable. We have already seen a close run referendum in Switzerland which would potentially have forced the SNB to hold huge amounts of gold and de facto move back towards a gold standard. The fear of a rerun could have prompted it to change tact.
  • Some have also noted that the SNB recently booked a CHF38bn profit from its operations last year. This provides a nice buffer against the loss which it suffered yesterday, and which it would inevitably suffered when it removed the floor. This seems to provide some further logic to the timing.
  • With ECB QE looming the SNB also sees an opportunity to unwind its huge FX reserves over 50% of which are in euros and a large part of which are in the form of government bonds – exactly the assets the ECB will be buying.
These factors combined I believe provide some logic behind the SNB move. But there remains one thing which I can’t get my head around. Why do they think they would not be able to handle the liquidity floor from ECB QE?
What does the SNB decision tell us about ECB QE?
  • As noted above, from a purely technical the SNB should in theory have been able to cope with the impact of ECB QE. Furthermore, according to all reports, the ECB is set to announce a QE programme of €500bn. As I discussed before, this is likely to be staggered over the coming months and may amount to monthly purchases of €10bn to €20bn. Even given the considerations above, did the SNB really think it couldn’t manage this? There is also a question as to why it did not retreat in a manged fashoin – why did it need to remove the floor so immediately rather than staggering the adjustment?
  • This leads to the suggestion that it is aware of something the broader market, and all of us, are not. Mainly, that the ECB QE will be of a much larger level, much more decisive and be imminently available.
  • It is hard to discern exactly what this would be – the programme could total €1 trillion and may involve larger monthly purchases, but this would be fraught with further political consequences for the ECB. Fundamentally, it is hard to imagine that the programme would be too far removed from what has been telegraphed so far. After all, ECB President Mario Draghi is a master in the art of central bank communication.
  • The other option of course is that this is a colossal misjudgement by the SNB, having significantly overestimated the impact of ECB QE. If that turns out to be the case then the credibility loss and political fallout which the SNB might sought to avoid with this move will almost certainly come to pass.
In the end, given the political and legal constraints which the ECB has been operating under, I find it hard to imagine that QE will be a long way from what has been forecast so far. This will leave the SNB facing some very tough questions.

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