Financial markets were roiled this week as losses currently estimated in the hundreds of millions were realised in the wake of the Swiss National Bank (SNB) abandoning their currency floor with the Euro. The problem for the market in the short term is the worry that higher volatility will force leveraged investors to sell down positions across the board, and that this selling begets more selling and so on. There is a bigger long term concern that we will get to later.
(For those interested or concerned about how RMG fared during this event. Both our FX and Macro strategies made money and are posting positive returns for January.)
With the deflationary concerns having escalated in recent weeks along with the declining oil price and rising market tensions, it is hardly surprising that an event leading to market losses of this scale would cause heightened concerns across all markets. The question remains as to whether these concerns be contained or will they increase in the days/weeks ahead. The answer, as with every similar period in the last few years, depends on the actions of our esteemed central bankers.
A side effect of the SNB move was an immediate assumption that the ECB will "do something big" next week. For months now, Draghi and his trusted lieutenants have been teeing the markets up for QE, and although there has been some obvious opposition to QE, Draghi has been clear that he would deliver if needed. Next week is now his time, and the markets will be sorely disappointed if the under-delivers.
So will the ECB go big next week likely ensuring a rally in risk assets? We simply don't know and so we are remaining extremely flexible in our portfolios with close to zero net exposure to either the Euro or Euro Area assets.
Back to the shock SNB move last week. Although we don't know exactly what triggered the timing of this move, we think the reasoning is quite simple. The SNB were having to be significantly more active in defending the 1.20 floor with the Euro, and their balance sheet (reported with a delay) was consequently rising dramatically, having already been at over 80% of GDP in December (see chart below). Simply put, the exploding SNB balance sheet was too high a price to pay, especially as opposition to recent policies had been made very public during the recent referendum.
We believe the SNB strategy of capping the Swiss Franc's value against the Euro was a flawed strategy from the beginning. In effect, the SNB were not only linking their currency to the German orthodox approach that forms the backbone of the Euro's credibility but they were also linking the Swiss Franc to Greece, Portugal and a host of other less orthodox countries that individually have significantly less credibility than Switzerland as a safe haven currency. Indeed, with the obvious pressures building in Europe (with QE likely from the ECB as a result) and Greece yet again at the centre of the political debate, the SNB's currency floor was looking increasingly vulnerable for a number of weeks.
This brings us onto the first of two major issues that we believe are becoming the most significant factors for investors to consider. First, the SNB has lost credibility. They have lost tens of billions of Swiss Francs on their FX policies since 2009 which must be the largest single loss in the history of foreign exchange markets. Secondly, their policy encouraged some market participants to believe they could short or borrow Swiss Francs (reinvesting into higher yielding assets - a form of carry trade) with the certainty that they couldn't lose on that leg of the trade or so they believed. So now we know that traders/investors can lose large sums of money blindly believing that central banks have their backs!!
If traders can lose money blindly taking risks assuming the SNB would not allow them to lose money, then we have to entertain the thought that the same could happen to those assuming the Fed and the ECB have their backs via QE and zero rates. Could it possibly be that leveraged players who are short the Yen and long Japanese stocks assuming Japanese QE will actually lose money?
At RMG, we are huge believers in a free market setting the right price for goods/services/assets. When central banks intervene, it should be in extreme circumstances only and not constantly trying to force prices higher for assets and weaken exchange rates (we are not even sure how successful these policies have been for the real economy, and we are certain that we haven't seen the true cost of undertaking these policies. That will have to be considered another day otherwise we would never finish writing this piece).We also believe that history will look back unkindly on all of these policies.
If investors begin to believe that the Fed PUT is much further below the market than they would like, and liquidation pressures rise quickly, who are they going to sell to? Regulators including central banks have built a market structure that is simply not robust enough to absorb intense selling. Liquidity is at a huge premium in markets nowadays, as seen this week in FX, last October in the US Government bond market, and daily in the Junk and EM bond markets. Banks simply do not make markets in size anymore and High Frequency Traders step away from disorderly markets. When there is no one to take the other side of the trade, an avalanche of selling causes huge "air pockets" as seen in Swiss Franc trading this week. And who wants to be exposed to that sort of risk?
So the Swiss move this early in the year makes for an incredibly interesting and probably volatile 2015. We believe that nearly all markets are overvalued due to years of central bank largesse and if markets begin to question their credibility, then we will see many more air pockets such as were seen this week. Of course, the ECB, BoJ, FED and PBoC can appease investors and soothe their concerns by changing a bit of language here and adding some liquidity there but their policies are having a decreasing impact on markets and are simply adding to the size and scale of potential unintended consequences.
For our part, we remain cautious on equities and believe that further market stresses this year will ensure that no major central bank will raise rates for a very long time to come. The one asset that should benefit in a period of declining central bank credibility is Gold, which is up more than 3% since just after the SNB decision.