The January 15th decision by the Swiss National Bank (SNB) to discontinue its defense of the Swiss franc (CHF)1.20/euro (EUR) upper limit not only ambushed global asset markets, but – in doing so – triggered a “black swan” event that engulfed them in turmoil and touched off yet another round of risk aversion among investors. Repudiation of the CHF1.20/EUR cap by the Swiss central bank precipitated rapid double-digit franc appreciation on its euro cross that caught the foreign exchange market short francs, intensifying volatility and instigating a record number of transactions – 2.26 million, precisely, amounting to USD9.2 trillion (99.5 percent of which changed hands in a span of scarcely forty-five minutes) for settlement (t+2) on January 20.
Prior to the SNB’s unexpectedly resolute move, the Swiss Market Index (SMI) had been outstripping all its global rivals irrespective of the reserve currency in which its return is denominated. Curiously, though, Swiss shares have sold off sharply since the mid-month decision to abandon the CHF1.20/EUR quasi-peg. In fact, since then, the SMI has performed the worst worldwide when expressed in CHF and EUR terms and ranked second from last on a US dollar (USD) basis as investors, in pursuit of financial security, forsake Swiss equities in favor of debt issuance of the Swiss Confederation.
Ten-year Swiss bond yields, meanwhile, plunged 24 basis points (bps) to 0.08 percent in the first fifteen days of 2015 and, then, slid another 17 bps to -0.09 percent afterwards. Spread enlargement of ten-year Swiss sovereign debt yields to those of Germany of the same duration gave way to a steep compression amid an accelerating flight to quality, translating into positive, double-digit price returns denominated in dollars or euros of Swiss government fixed income issuance year-to-date. Another beneficiary of the risk antipathy sparked by the Swiss monetary authorities’ desertion of the CHF1.20/EUR maximum has been gold – the value of which has surged 9.4 percent cumulatively since end-2014 and 6.6 percent from end-December to January 15th.
What prompted the Swiss central bank to undertake such a drastic policy reversal just two days after a key official, SNB Vice President Jean-Pierre Danthine, re-affirmed the currency lid as a “pillar of our monetary policy?” SNB policymakers justified their unanticipated action based on their anticipation of more extraordinary credit relaxation by the European Central Bank (ECB), which was confirmed by ECB President Mario Draghi at a press conference following an executive board meeting earlier today. Foreign exchange intervention to hold CHF/EUR at or near CHF1.20 had already increased the SNB’s balance sheet to 81 percent of nominal GDP as of last November, accompanied by the monetary base (high-powered money) soaring to 60 percent of GDP.
Enhanced unconventional stimulus by the ECB through purchases of sovereign debt would put more upward pressure on the CHF relative to the EUR via safe haven demand and increase already strong flows into Swiss franc-denominated assets, necessitating further intervention to stabilize the CHF and augmenting too strong money supply growth. Hence, a re-normalization of the bank’s credit policy was in order and the outright elimination of the currency maximum, in restoring the franc to a fully free-float in the foreign exchange markets, liberalized SNB monetary policy from its nexus to that of the ECB implied by its implementation of the currency ceiling more than three years ago.
In light of the foregoing, needless to say, Switzerland’s domestic economy will probably pay a hefty toll in spite of compensatory SNB action on the money market front in having adopted a 50 bp reduction in the rate of its overriding three-month CHF Libor policy target to -0.75 percent, the midpoint of its -0.25 to -1.25 range. The perplexing challenge facing the authorities in Bern, in the opinion of Global Markets Intelligence (GMI), is rebalancing the country’s excessive exposure to exports, which is roughly 66 percent of nominal GDP, in the direction of private consumption.
With a high 16.5 percent savings rate and household spending only 55 percent of money GDP, the Swiss economy appears at a critical crossroads in the face of undue CHF strength. Transforming consumption habits would pose a major historic hurdle because advancing a diversion of funds from savings to purchases of staples and luxuries by consumers to invigorate internal demand and accelerate living costs from their current deflationary state could take much time for households to make the psychological and financial adjustment.
GMI is convinced a reduction in its recommendation to market-neutrality is substantiated fully by its expectation of a deteriorating domestic macroeconomic environment for the foreseeable future. As for Swiss debt markets, investments – regardless of maturity – should proceed to appeal to foreign investors on account of persistent event risks in the Middle East and Eastern Europe as well as potential credit risks that might arise in the euro bloc and elsewhere.