Last week the Swiss National Bank (SNB) surprised the market in deciding to end the currency floor mechanism that had been in place since the eurozone crisis in mid-2011. The market reaction was large by any standards, ranging from a 90 standard deviation event compared to option pricing the day beforehand to a 30 standard deviation event compare to realised volatility through the 2007/2008 financial crisis period. For context, a 10 standard deviation is often considered as the most extreme scenario for risk analysis. While the SNB anticipated significant market volatility, and would have had information on the extent of market positioning that is not publicly available, it is likely that such an extreme move was still an unwelcome surprise.
For the rest of the world, the fate of the Swiss economy may not be a primary concern but the financial market linkages could have a global impact. Based on the latest Bank for International Settlements (BIS) data on over-the-counter (OTC) derivative positions, the notional exposure to Swiss Franc (CHF) currency trades and currency options was nearly $4 trillion at the end of H1 2014, reasonably similar to levels over the previous year. While there is considerable uncertainty around how much exposure may net out, we estimate an approximate range for the wealth transfer that occurred as a result of the CHF appreciation on Jan 15 to be between $100bn and $500bn. While some early casualties are attracting attention in the media, there are likely to be significant exposures on positions that will not settle for a couple of months and so we remain cautious of further turbulence in the markets.
At the same time as abandoning the currency floor, the SNB cut rates by 50bps to target LIBOR at -75bps. In order to gauge the relative impact of the trade weighted exchange rate, equity and yield moves we favour examining the overall impact on monetary conditions. Based on our analysis the effect of the currency move is significantly greater than the effect of lower rates, taking Swiss monetary conditions from levels that were reasonably stimulative to the tightest levels since the introduction of the currency floor in 2011.
The Swiss economy is not well placed to face such a large tightening of policy, with the SNB’s December monetary policy outlook forecasting four quarters of negative inflation even before the further impact of the latest oil prices declines are considered. The challenge for the SNB going forward will be how to stimulate the economy and prevent a serious economic decline.
With interest rates already below the cost of storing banknotes, it is not clear that further lowering of rates will be possible from a practical perspective. It would be natural to expect financial market participants to take the opportunity to borrow CHF at negative rates, place banknotes into storage and earn positive carry with little risk. Quantitative easing is a possibility, but with a small stock of government bonds available to purchase such a programme would likely have to focus on equities, and thus entail significant fiscal risks. The most likely reaction in our opinion would be to ask the government to provide fiscal stimulus, confirming the central bank is not able to operate monetary policy truly independently of the government. Indeed, it is this inability to avoid monetary policy imposing fiscal risks that endanger the wealth of the nation that is widely believed to be behind the decision to abandon the currency floor in preference to accumulating further foreign exchange reserves.