In Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations, the 18th Century philosopher speaks of the division of labor and free trade, the limits of government intervention, price discovery and the importance of the free market, all of which were theories that many believed transitioned economics to the “modern” and spawned Capitalism. Much of Smith’s work informs that which we are experiencing today in the financial markets: government intervention in the form of quantitative easing, falling interest rates, the precipitous fall of energy prices and other industrial commodities, and most recently, extreme volatility in currency values. Adam Smith explains price discovery is the natural process by which buyers and sellers solve the supply and demand equation to arrive at a “market” price. In the case of the Swiss franc, government intervention was lifted and price discovery was immediately found at a 20% uptick.
Switzerland’s culture of bank secrecy, which dates back hundreds of years and was codified in 1934, has made Swiss banks in Geneva and Zurich safe havens for the ill-gotten wealth of “bad guys” for decades. Switzerland’s bank secrecy laws are, in no small way, responsible for this tiny country’s ability to maintain their neutrality and national sovereignty. Swiss neutrality, even through two World Wars, allowed the Swiss banking sector to thrive throughout the years. Switzerland’s central bank, the Swiss National Bank (SNB), has historically been an able steward of the country’s finances with virtually zero inflation and the legal requirement that a minimum of 40% of the total outstanding currency be backed by gold reserves. Accordingly, the Swiss franc has long been recognized as the most stable of currencies. So much so that as the Great Recession spread to a global financial crisis, worried wealth from across the globe began to migrate to the Swiss franc pushing the currency to new highs and causing worry for the export-driven Swiss economy.
When the euro zone debt crisis developed, the Swiss franc soared in value relative to major currencies. In September of 2011 the SNB sought to mitigate the rise by fixing its currency against the euro at a rate of 1.2 Swiss. Within minutes of the SNB action, the euro, the dollar and the pound sterling appreciated 8-9% against the Swiss franc – a move that was described at the time by one experienced economist as the “single largest foreign exchange move I have ever seen.” Enforcing the franc/euro peg required the SNB to buy currencies in unlimited quantities, and so they did. Over the ensuing three years, the SNB expanded their balance sheet five-fold by printing Swiss francs to amass an ever increasing mound of euros. By 2014, this amounted to $480 billion, a sum equal to roughly 75% of Swiss GDP. Suddenly, the staid bankers of Switzerland, renowned for prudent fiscal stewardship, were huge owners of a depreciating foreign currency to which their own currency was pegged. The SNB now knows that there is a limit to unlimited quantities, and apparently the limit is $480 billion.
The European Central Bank(ECB) announced a major quantitative easing program this week, a move that will likely drive the value of the euro even lower, and the SNB chose to capitulate to the inevitable by abandoning the franc/euro peg. Now that the Swiss franc has been unhinged from the depreciating euro, the spring-loaded value of the franc sits 18% higher than one week ago, and the Swiss stock market is 13% lower. The short term impact of the SNB decision will be problematic for the Swiss economy, but will likely be better for their economy in the long run. In the meantime, the SNB will lick their wounded reputation as they reread the writings of Adam Smith and reacquaint themselves with the free market and the process of price discovery.
So what happens now? A combination of the coming ECB quantitative easing program and the Swiss no longer buying euros will likely further depress the value of the euro relative to most major currencies. Moreover, interest rates are likely to move lower across the board including rates that are already negative. We now have an active discourse on “negative interest rate policy,” something that has been largely theoretical and without actual practice. We do well to remember that quantitative easing on the scale seen in the US, in Japan, and soon in the EU, are monetary experiments designed to combat deflationary pressures, and the results are unknown. Financial markets like predictability, and “unknown” doesn’t reconcile with “predictable.” Accordingly, we are likely to see heightened volatility as the financial markets navigate deflationary terrain.
We have meaningfully reduced our international exposure and have allocated assets to intermediate and longer dated treasuries, both of which help to mitigate the risks of the current environment.