Three developments from last week will influence the global capital markets in the period ahead: the Swiss National Bank’s decision to aggressively prevented further appreciation of the franc; the resignation of Jurgen Stark from the European Central Bank, following on the heels of the resignation of Axel Weber earlier this year; and the strong suggestion of greater monetary and fiscal response by the US.
On balance, these drivers will likely continue to fuel a recovery in the US dollar.
The Swiss National Bank has signaled a willingness to keep the euro above CHF1.20. It is willing to sell unlimited amounts of Swiss francs to ensure this. There has been some speculation in the media and markets that in addition to intervening in the swaps market, the SNB has also intervened in the options market.
Even though the SNB has wide political support for its actions, its strategy is fraught with risk. Consider that it sells Swiss francs, which is fine as it has the power of the printing press, but what does it buy?
The simple answer is that it buys euros and invests those euros in core euro zone bonds, like German Bunds and French Oats. Yet this will risk exacerbating a key force that has been underpinning the Swiss franc in the first place—the widening spread between core and periphery yields within the euro zone.
Some observers have suggested that the SNB ought to buy Italian and Spanish bonds. There is a certain logic to it, but does not seem very likely. Buying triple-A bonds is one thing; buying lower rated peripheral bonds is a horse of a different color. As of the end of June 83% of the SNB’s currency reserves were invested in AAA bonds and 14% in AA-rated bonds. It would be compounding the balance sheet exposure.
The ECB has already been criticized in some quarters for its purchases of peripheral bonds on grounds that it is becoming a “bad bank”—warehouse for distressed assets that private sector investors do not want. The SNB does not seem to want to go down that path. Even its diversification of its currency holdings has not ventured far away from the traditional reserve currencies, despite the apparent fashion. At the end of the first half, 93% of the SNB reserves were held in euros (55%), dollars (25%), yen (10%) and sterling (3%). The Canadian dollar accounted for 4% and a unreported combination of Australian dollar and Singapore dollars, Swedish krona and Danish krone accounted for 3%.
Mark-to-Market or Not
On the other hand, the cost of intervention is less disadvantageous. The cost of intervention is often thought of as the difference between the domestic interest rate and the rate that can be earned on the currencies being bought. Swiss interest rates are well below the euro zone, the US and even Japan.
If the SNB’s form of quantitative easing is successful and hot money is discouraged from finding a home in Switzerland, there is not worry about marking-to-market it reserves. Marking-to-market is only a problem if the operation is not successful and the Swiss franc strengthens anew.
Some of the fallout will be minimized by the fact that the SNB has secured a political consensus. The potential paper loss from the intervention was widely seen as preferable to the actual losses incurred by Swiss businesses and the cost of potential deflation that is already appearing on the horizon. The political consensus also minimizes the legal and constitutional issues which might be raised ahead of next month’s national elections.
There are also other steps the SNB could take. For example, if does not have to mark-to-market. The US, for example, does not mark-to-market its gold reserves (the most in the world). The SNB could also, if it chose, establish a sovereign wealth fund, perhaps like Norway’s petroleum fund.
Our Currency, Your Problem
Yet like the Dutch boy sticking his finger into the hole in the levee, the SNB’s action may simply deflect the hot money flows elsewhere. The Swiss determination may export the problem elsewhere. The yen, which has been the other major safe haven, is a potential candidate, though there did not appear to be an immediate reaction. The new Japanese government is led by the former finance minister who authorized a record amount of yen to be sold in a single day (JPY4.5 trillion, ~$50 bln) in early August.
Funds did appear to flow into the Scandinavian currencies. Norway appeared to be the most significant beneficiary, but the Norges Bank threatened unilateral action to prevent marked appreciation of the krone. Sweden’s krona also rallied, helped by stronger than expected industrial production and orders data.
The Riksbank appears to be more tolerant of currency appreciation than the Norges Bank. Denmark, which pegs its krone tightly to the euro, responded to its currency strength by shaving its two week repo rate in August. Additional easing of rates is possible.
A problem for real money managers, as opposed to speculators, is that asset markets in Norway, Denmark and Sweden are relatively small. Many fund managers cannot take on naked currency exposure—that is just currency exposure without the underlying asset. The minimization of the role for this market segment impacts liquidity and volatility.
Some observers insist that the SNB’s move opens yet another front in the currency war. Yet, following the footsteps of the Italian economist, Ricardo Parboni, investors might be better served recognizing that the foreign exchange market itself is, and has always been an arena in which nation-states compete. There is nothing unusual about this. It is not the first time, for example, the Swiss have tried checking the appreciation of the franc. The war imagery is a function of our era, and is predicated on the collapse of the fixed (but adjustable) Bretton Woods regime.
Europe in Crisis
The strength of the Swiss franc was not a function of US monetary or fiscal policy. The clear driver of the franc’s appreciation was the persistent and apparently deepening crisis in the euro zone. Clear, compelling and politically feasible solutions remain as elusive as ever. It is difficult to see the way forward, but the political and economic cost of going backward (devolution and break-up of the monetary union) also seems prohibitively high.
Stark’s resignation, apparently over the ECB’s decision to resume sovereign bond purchases (seemingly especially of Italy and Spain, which are not in a formal fiscal program with the EU/IMF) and the German president’s strong accusation that those bond purchases were “legally questionable”. It could hardly come at a less opportune time.
He was, rightly or wrongly, perceived by many in the German establishment as a strong protector of Germany’s interests, as the key creditor nation on the ECB council. His departure will make it harder rather than easier for Merkel to secure a majority of her governing coalition to approve the July 21 agreement that reforms/restructures the EFSF and a second Greek assistance program. Merkel enjoys a slim 19 seat majority in the lower chamber of the German parliament.
A Drag for Draghi
His resignation is also a blow to the ECB. It undermines its credibility. Trichet has one more ECB meeting to chair and then the mantle of leadership passes to Italy’s Draghi. A representative from the periphery has not headed up the ECB in its brief history.
Using word cues, Trichet has signaled that the mini rate hiking cycle (April and July) is over. This means that Draghi will not have an opportunity in the early days of his tenure to establish his anti-inflation credentials by hiking rates as so many had previously expected.
In fact, by indicating that monetary policy remains accommodative, Trichet make be making it more difficult for Draghi to respond to the softening of the economy and easing of price pressures that largely seem to have already been baked in the cake. It may force the new ECB president to be reactive rather than proactive.
With Stark departing and Draghi waiting in the wings, fears in some quarters in Germany, but also Austria, Finland and the Netherlands, are that the values and interests of the debtor members have captured the ECB, which was supposed to be the bastion of hard money and monetary prudence. Stark’s departure represents a deepening crisis within the ECB and for Merkel.
In contrast to the policy paralysis in Europe, US policy makers are on the move. What is ironic is that July personal consumption expenditures and trade balance figures suggest that the US economy has accelerated at the start of H2. Money supply growth has accelerated and C&I loans have increased as banks have eased their lending standards.
The US economy may be growing among the fastest in the G7, but US policy makers say it is insufficient. The Federal Reserve never called its $600 bln of bond purchases that ended in June as quantitative easing. It was trying to ease credit conditions and it appears to be preparing additional steps to address the dysfunction. Unlike the ECB, judging from Weber and Stark’s actions, the Federal Reserve has demonstrated a great capacity to cope with different views.
Trichet is keen to draw a distinction between monetary policy proper (interest rates) and its emergency liquidity provisions, but he is criticized for blurring the distinction between monetary and fiscal policy. Bernanke seems more cognizant of the limitations of monetary policy to repair the economy.
It seems likely that some parts of Obama’s jobs bill will be approved by Congress. However, it may be scaled back in its final form. Still the lines are drawn. The US will pursue more stimulus, though it is growing faster than Europe. The dollar and US asset markets are poised to be significant beneficiaries of this stark contrast.
Disclosure: No positions