Threedevelopments from last week will influence the global capital markets in theperiod ahead: the Swiss National Bank’sdecision to aggressively prevented further appreciation of the franc; theresignation of Jurgen Stark from the European Central Bank, following on heelsof the resignation of Axel Weber earlier this year; and the strong suggestionof greater monetary and fiscal response by the US. On balance, these drivers will likelycontinue to fuel a recovery in the US dollar.
TheSwiss National Bank has signaled a willingness to keep the euro aboveCHF1.20. It is willing to sell unlimitedamounts of Swiss francs to ensure this. There has been some speculation in the media and markets that inaddition to intervening in the swaps market, the SNB has also intervened in theoptions market.
Eventhough the SNB has wide political support for its actions, its strategy is fraughtwith risk. Consider that it sells Swissfrancs, which is fine as it has the power of the printing press, but what doesit buy? The simple answer is that itbuys euros and invests those euros in core euro zone bonds, like German Bundsand French Oats. Yet this will risksexacerbating a key force that has been underpinning the Swiss franc in thefirst place—the widening spread between core and periphery yields within theeuro zone.
Someobservers have suggested that the SNB ought to buy Italian and Spanishbonds. There is a certain logic to it,but does not seem very likely. Buying triple-Abonds is one thing; buying lower rated peripheral bonds is a horse of adifferent colour. As of the end of June83% of the SNB’s currency reserves were invested in AAA bonds and 14% inAA-rated bonds. It would be compoundingthe balance sheet exposure.
TheECB has already been criticised in some quarters for its purchases ofperipheral bonds on grounds that it is becoming a “bad bank”—warehouse fordistressed assets that private sector investors do not want. The SNB does not seem to want to go down thatpath. Even its diversification of itscurrency holdings has not ventured far away from the traditional reservecurrencies, despite the apparent fashion. At the end of the first half, 93% ofthe SNB reserves were held in euros (55%), dollars (25%), yen (10%) andsterling (3%). The Canadian dollaraccounted for 4% and a unreported combination of Australian dollar andSingapore dollars, Swedish krona and Danish krone accounted for 3%.
Onthe other hand, the cost of intervention is less disadvantageous. The cost of intervention is often thought ofas the difference between the domestic interest rate and the rate that can beearned on the currencies being bought. Swiss interest rates are well below the euro zone, the US and evenJapan.
Ifthe SNB’s form of quantitative easing is successful and hot money isdiscouraged from finding a home in Switzerland, there is not worry aboutmarking-to-market it reserves. Marking-to-market is only a problem if the operation is not successfuland the Swiss franc strengthens anew.
Someof the fallout will be minimized by the fact that the SNB has secured apolitical consensus. The potentialpaper loss from the intervention was widely seen as preferable to the actuallosses incurred by Swiss businesses and the cost of potential deflation that isalready appearing on the horizon. Thepolitical consensus also minimizes the legal and constitutional issues whichmight be raised ahead of next month’s national elections.
Thereare 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-marketis 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, YourProblem
Yetlike the Dutch boy sticking his finger into the hole in the levee, the SNB’saction may simply deflect the hot money flows elsewhere. The Swiss determination may export theproblem elsewhere. The yen, which hasbeen the other major safe haven, is a potential candidate, though there did notappear to be an immediate reaction. Thenew Japanese government is led by the former finance minister who authorised arecord amount of yen to be sold in a single day (JPY4.5 trillion, ~$50 bln) inearly August.
Fundsdid appear to flow into the Scandinavian currencies. Norway appeared to be the most significantbeneficiary, but the Norges Bank threatened unilateral action to prevent markedappreciation of the krone. Sweden’skrona also rallied, helped by stronger than expected industrial production andorders data.
TheRiksbank appears to be more tolerant of currency appreciation than the NorgesBank. Denmark, which pegs its kronetightly to the euro, responded to its currency strength by shaving its two weekrepo rate in August. Additional easingof rates is possible.
Aproblem for real money managers, as opposed to speculators, is that assetmarkets in Norway, Denmark and Sweden are relatively small. Manyfund managers cannot take on naked currency exposure—that is just currencyexposure without the underlying asset. The minimization of the role for this market segment impacts liquidityand volatility.
Someobservers insist that the SNB’s move opens yet another front in the currencywar. Yet, following the footsteps of theItalian economist, Ricardo Parboni, investors might be better served recognizingthat the foreign exchange market itself is, and has always been an arena inwhich nation-states compete. There isnothing unusual about this. It is notthe first time, for example, the Swiss have tried checking the appreciation ofthe franc. The war imagery is a functionof our era, and is predicated on the collapse of the fixed (but adjustable)Bretton Woods regime.
Europe in Crisis
Thestrength of the Swiss franc was not a function of US monetary or fiscalpolicy. The clear driver of the franc’sappreciation was the persistent and apparently deepening crisis in the eurozone. Clear, compelling and politicallyfeasible solutions remain as elusive as ever. It is difficult to see the way forward, but the political and economiccost of going backward (devolution and break-up of the monetary union) alsoseems prohibitively high.
Stark’sresignation, apparently over the ECB’s decision to resume sovereign bondpurchases (seemingly especially of Italy and Spain, which are not in a formalfiscal program with the EU/IMF) and the German president’s strong accusationthat those bond purchases were “legally questionable”. It could hardly come at a less opportunetime.
Hewas, rightly or wrongly, perceived by many in the German establishment as a strongprotector of Germany’s interests, as the key creditor nation on the ECBcouncil. His departure will make itharder rather than easier for Merkel to secure a majority of her governingcoalition to approve the July 21 agreement that reforms/restructures the EFSFand a second Greek assistance program. Merkel enjoys a slim 19 seat majority in the lower chamber of the Germanparliament.
A Drag for Draghi
Hisresignation is also a blow to the ECB. Itundermines its credibility. Trichet hasone more ECB meeting to chair and then the mantle of leadership passes theItaly’s Draghi. A representative fromthe periphery has not headed up the ECB in its brief history.
Usingword cues, Trichet has signaled that the mini rate hiking cycle (April andJuly) is over. This means that Draghiwill not have an opportunity in the early days of his tenure to establish hisanti-inflation credentials by hiking rates as so many had previously expected.
Infact, by indicating that monetary policy remains accommodative, Trichet make bemaking it more difficult for Draghi to respond to the softening of the economyand easing of price pressures that largely seem to have already been baked inthe cake. It may force the new ECBpresident to be reactive rather than proactive. WithStark departing and Draghi waiting in the wings, fears in some quarters inGermany, but also Austria, Finland and the Netherlands, that the values andinterests of the debtor members have captured the ECB, which was supposed to bethe bastion of hard money and monetary prudence. Stark’s departure represents a deepeningcrisis within the ECB and for Merkel.
Incontrast to the policy paralysis in Europe, US policy makers are on themove. What is ironic is that Julypersonal consumption expenditures and trade balance figures suggest that the USeconomy has accelerated at the start of H2. Money supply growth has accelerated and C&I loans have increased asbanks have eased their lending standards.
TheUS economy may be growing among the fastest in the G7, but US policy makers sayit is insufficient. The Federal Reservenever called its $600 bln of bond purchases that ended in June as quantitativeeasing. It was trying to ease creditconditions and it appears to be preparing additional steps to address thedysfunction. Unlike the ECB, judgingfrom Weber and Stark’s actions, the Federal Reserve has demonstrated a greatcapacity to cope with different views.
Trichetis keen to draw a distinction between monetary policy proper (interest rates)and its emergency liquidity provisions, but he is criticised for blurring thedistinction between monetary and fiscal policy. Bernanke seems more cognisant of the limitations of monetary policy torepair the economy.
Itseems likely that some parts of Obama’s jobs bill will be approved byCongress. However, it may be scaled backin its final form. Still the lines are drawn. The US will pursue more stimulus, though itis growing faster than Europe. Thedollar and US asset markets are poised to be significant beneficiaries of thisstark contrast.
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