From Switzerland With Love: Some Hard Truths About Central Banks And Risk

Jan 23 2015 | 8:54am ET

By Neil Azous
Founder & Managing Member
Rareview Macro LLC

There are moments when it takes a dramatic event to remind the markets of some hard truths. Ever since the crash of 2008, central banks across the globe have developed a range of unorthodox policies in an effort to combat the economic shocks that hit the world economy during that crisis and its aftermath.  Although these policies have taken a variety of forms – from liquidity programs, to asset purchases and currency pegs, etc. – in one way or another they all had a common goal.  Central banks attempted to influence the price of financial assets as a way of improving the real economy. But as the Swiss have just taught us, that can be a lot harder in practice than it is in theory, and it doesn’t last forever.

After an uncertain start, the markets have generally played along with the policy, moving out the risk curve as central banks successfully reduced volatility and risk premia across a range of financial assets. As it turned out, policymakers’ success in influencing financial market pricing gave them an aura of credibility, if not infallibility amongst market participants, who in some ways seemed to become resigned to central bank omnipotence. Wherever the central bankers led, investors followed.

Until this year, that is. On January 15, the Swiss National Bank (SNB) announced that it was abandoning its policy of defending a 1.20 floor for the value of the euro against the Swiss franc, a mere three days after reiterating its commitment to that peg. The reaction was immediate and violent – the Euro-Swiss (EUR/CHF) currency pair gapped some 20% lower and extended its losses even further before eventually stabilizing around parity (i.e. ~1.00). Although the final reckoning has yet to be made, a broad range of market participants, including hedge funds, real money investors, banks, broker dealers, retail investors, and Swiss corporations all lost a lot of money.

The magnitude of the move came as no surprise, however, to seasoned observers of managed currency regimes. Similar routs followed the breakdown of other currency pegs going back to the collapse of the Bretton Woods system in the early 1970’s, or the forerunner of the euro, the Exchange Rate Mechanism (ERM), in the early 1990s.  

In the wake of that, a key question has to be asked. Why did such a broad swathe of investors risk catastrophic loss for such modest prospective gains? The answer, of course, is that they believed in the inviolability of the currency floor and were explicitly encouraged to do so by the SNB. In turn that allowed investors to ignore the gap risk of a peg break because of the credibility and apparent infallibility of the SNB.

And yet they were wrong. The SNB could not be trusted in the end, and that has exposed a few hard truths about central bank policy and financial market risk taking.

Hard Truth #1: Extraordinary policies do not live forever. While certain central banks are still running (and indeed unveiling!) full-bore unorthodox policies, such measures do not have an infinite shelf life.  Although some investors seem to cynically believe that monetary policy is run almost as a popularity contest (with central banks not wanting to do anything to upset markets), the fact is that the economic impact of the crisis is now waning in some economies, and with it the requirement for extraordinary levels of policy accommodation. While the SNB’s change of policy was particularly abrupt, and unlikely to be duplicated by other central banks to the same degree, investors need to consider the possibility that policy can begin to normalize elsewhere, particularly the United States.  

Although the Fed’s intention to gradually lift policy rates has apparently been very-well flagged, the markets still prefer to believe that the Fed will err on the side of the status quo. Comparing current market pricing with the lower half of the infamous Fed dot plots (reflecting the apparent “dovish core” around Chairwoman Janet Yellen), we find that markets have priced in significantly less tightening than the Fed itself appears to anticipate. As the SNB has just demonstrated, the cost of disregarding the risks of tightening can be very high.

Hard Truth #2: Central banks do not possess infinite credibility and are not naturally disposed to help speculators make money.
To be sure, the way that the Swiss handled their policy change (reiterating their commitment to the policy on a Monday only to abandon it that Thursday) was at best naïve, and at worst an outright betrayal of the markets. It doesn’t automatically follow that other banks will act the same way. That said, the Swiss example should at least introduce a risk premium into investment positioning which has, up until now, taken monetary policy frameworks as a given.

Moreover, while the interests of central banks and investors have been aligned for the past few years, they are not natural bedfellows. The collapse in volatility and risk premia would appear at odds with the post-crisis regulatory emphasis on financial stability. The apparent assumption in some quarters that the Fed or other central banks will always ride to the rescue in the event of a collapsing or very volatile market may well turn out to be wrong. Indeed, while many observers expressed consternation at the way the SNB policy shift was executed, some former policymakers approved of it, even appearing to engage in a little schadenfreude at the market fallout.

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