The crowded trading floor immediately fell into an edgy silence, as traders and sales dealers stared at their monitors trying to figure out what just happened. The prices on their screens had frozen, as the market in both EUR-CHF and USD-CHF temporarily seized up following a sudden 30% crash in the franc. This was an incredible occurrence; markets in major currency pairs don’t just stop working like that. Foreign exchange (FX) is the most liquid market in the world – it’s not supposed to trade like some esoteric structured credit derivative.
However, it did happen. The global currency market in two major currency pairs did (temporarily) stop working, and the fall-out of this dramatic occurrence, and more importantly of what lay behind it, will have significant repercussions in both the short and long term. There are three conclusions that are particularly important:
1. The limits of extreme monetary policy have been exposed:
The expansion of the SNB’s balance sheet might not have been the result of US-style quantitative easing (QE), but both strategies represented extraordinary levels of activism by the respective central banks. In the case of the SNB, its assets swelled to over 80% of Swiss gross domestic product (GDP) – to put this into perspective, after three rounds of QE the Federal Reserve’s balance sheet represented about a quarter of US GDP.
This ballooning has created a big risk for the SNB, as it had been simultaneously selling liabilities denominated in CHF to sterilise its intervention (to ensure its colossal money printing operation would not cause inflation). As any corporate treasurer knows, a balance sheet in which the assets are held in one currency and the liabilities in another spells trouble. The SNB clearly feels that these risks are now so big that allowing a massive appreciation of the CHF – in a country where exports represent over half of GDP – is a price worth paying, to ensure this risk does not metastasize.
The risks for other central banks will not be exactly the same (especially with respect to the currency mismatch), but the fundamental lesson here is that the gross size of the balance sheet does matter -not just the net. This will restrict the ability of any country, or currency block, from engaging in QE ad infinitum. The Bank of Japan (BoJ) should take note.
2. Volatility is back with a bang:
Since hitting an all-time low back in the summer, currency volatility is now officially back. Last Thursday’s price action pushed the JP Morgan G7 volatility index – a measure similar to the VIX in equities – to a level of 11.3%. This represents an effective doubling of (implied) currency volatility over the past six months, and we are now back above the long-term average of around 10%.
What’s more, it is not just currencies which will be impacted. The financial market is similar to a highly interconnected ecosystem, like a tropical rainforest. If one component of this ecosystem is disrupted, other areas will quickly feel the effects – Thursday’s currency market turmoil prompted European equites to sell off sharply, only to rally higher as treasury yields plunged.
The reasons for this interconnectedness is a combination of indirect feedback loops (for example a hedge fund which loses money on long EUR-CHF position may need to sell equities to fund redemption requests) and direct linkages. For instance, as a result of their massive balance sheet expansion, the SNB holds over US$25bn in about 2,500 US stocks. What will be the effect of the SNB’s sudden change in strategy on this huge market position? Such uncertainty is often the trigger for fresh bouts of market turbulence.
3. The potential impact of currency volatility is generally underestimated:
Currencies typically exhibit lower volatility than other asset classes, such as equities, commodities or bonds. This can fool investors and treasurers into thinking currencies are lower risk than these other exposures – especially as many of us have been trained to equate volatility with risk.
This is a dangerous assumption. While currencies are less volatile most of the time, when they move, they can move a lot. The CHF moved more than 40% against the EUR on January 15 – and almost as much against the USD. When was the last time the S&P 500 moved 40% in a single day? (Answer: never). Many companies stress test their financial metrics against an arbitrary 10% currency movement; this should not be considered an adequate assessment of corporate vulnerability to currency risk. Ask any Swiss exporter.
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