Today began the next phase of the great monetary experiment, as reality plays a trump card.

Summary: Today began the next phase of the great monetary experiment, the collision of Central Bankers’ bold promises with reality.  History suggests skepticism about the odds of CB’s success (e.g., see the many unbreakable currency pegs and unions which broke). Today the Swiss National Bank folded its cards. Here we discuss the significance of this to them and to us.  This is part one; see tomorrow’s post for the conclusion.

Wizard of Oz
Bow before our Monetary Wizards!

Since the crash, governments of the western nations have conducted the greatest economic experiment ever, with us as the subjects of unprecedented monetary and fiscal stimulus. We have had massive deficits, long periods of zero interest rates (for some now, negative interest rates), and repeated rounds of quantitative easing (in various forms). So far the results have varied by nation from good to great. But as with any experiment, preliminary results often don’t match the final tally. Today we began the next phase.  First here’s some background.

Switzerland’s bold monetary experiment.

“The minimum exchange rate remains for the foreseeable future the key monetary policy instrument. We’re prepared to buy unlimited amounts of foreign currencies and, if necessary, take further measures …. We will continue to defend the minimum exchange rate with utmost determination …”

— Thomas Jordan, President of the Swiss National Bank, 23 September 2014 — Speech in defense of the 1.20 peg to the Euro set in September 2011.

To keep their exports competitive in September 2011 the Swiss National Bank (SNB) set a minimum exchange rate (a ceiling to the Swiss Franc vs the Euro). In September 2014 President Jordan promised to print unlimited Swiss Francs to defend this level. Some were skeptics, such as the people at Grant’s Interest Rate Observer, 19 September 2014 — Excerpt:

Like a celebrity in flight from the paparazzi, the Swiss Confederation demands protection from its pesky admirers. … The {Swiss franc} is still, for many, the monetary bolt-hole of choice. To the Swiss, whose exports generate 54% of Switzerland’s GDP, it’s a kind of popularity they can live without — indeed, they insist, must live without. So the SNB prints francs.  It drew a monetary line in the sand three years ago: The franc shall not rally through the 1.20-to-the-euro mark, the authorities commanded in September 2011. To enforce this dictum, they bought euros with newly created francs (the cost of production of the home currency being essentially zero).

What to do with the rising euro mountain? Invest it, of course. CFA fashion, the central bankers are diversifying across asset classes and currencies. Among these asset classes are equities, and among these currencies is the dollar. As of June 30, the Swiss managers held $27 billion in 2,533 different U.S. stocks, according to the bank’s latest 13-F report …

Here’s a metaphysical head scratcher. The Europeans conjure euros, which the Swiss buy with their newly materialized francs. The managers exchange the euros for dollars (also produced by taps on a keyboard) and with that scrip buy ownership interests in real businesses. The equities are genuine. The money, legally and practically speaking, is itself real.. But what is its substance? We mean, how is it different from air?

… In these stupendous interventions, the SNB is hardly unique. Nor is it alone as it attempts to undo, through administrative means, the distortions it creates through monetary policy. New “macro- prudential” directives have tightened standards for home-loan amortization schedules, minimum down payments, affordability, bank capital ratios, etc.

Grant’s recommendation:

{W}e venture that the SNB will sooner or later be forced to permit the franc to appreciate and thus to enrich the holders of low-priced, three-year call options on the Swiss/euro exchange rate. It’s a long shot, to be sure — the options are cheap for a reason — but we judge that the prospective reward is worth the obvious risk.

Four months later their recommendation paid off — big. Bloomberg describes the fireworks:

In a surprise statement that sent shockwaves through equities and currency markets, the central bank ended its cap of 1.20 franc per euro … The franc appreciated as much as 41% to 85.17 centimes per euro, the strongest level on record, according to data compiled by Bloomberg.

…the SNB also moved the target range for the three-month Libor to between minus 1.25% and minus 0.25%, from the current range of between minus 0.75% and 0.25%.

None of 22 economists surveyed by Bloomberg News between Jan. 9 and Jan. 14 expected the SNB to get rid of its cap in 2015. Only four saw it abandoning the measures next year.

"Broken Promises" by Herrfous1
“Broken Promises” by Herrfous1.

What does the breaking of the SNB mean for the Swiss, and for us?

Bruce Krasting discusses the implications of the SNB’s broken promise.

I wrote about the Swiss National Bank being forced to abandon its currency peg to the Euro on December 3, December 8 and January 11. That said, I’m blown away that this has happened today. …The Swiss economy will rapidly fall into recession as a result of the SNB move. …the failure to hold the minimum rate will result in a one time loss for the SNB of close to $100B. That’s a huge amount of money. It comes to 20% of the Swiss GDP! If this type of loss were incurred by the US Fed it would result in a loss in excess of $2 Trillion!

In the coming days and weeks there will be more fallout from the SNB disaster. There will be reports of big losses and gains from today’s events. But that is a side show to the real story. We have just witnesses the collapse of a promise by a major central bank. The Fed, Bank of Japan, ECB, SNB and other Central Banks have repeatedly made the same promises over the past half decade …

I never believed in these promises, but the vast majority of those who are active in financial markets did. The entire world has signed onto the notion that Central Banks are all powerful. We now have evidence that they are not. … Those who believed in Jordan’s promises now have red ink on their hands – lots of it! The next central bank that will come into the market’s cross hairs is the ECB.

…We’ve just taken a huge leap into chaos. The linchpin of the capital markets has been the trust in the CBs. The market’s anchors have now been tossed overboard.

Krasting nails it. Central Bankers have promised unlimited action to maintain specific aspects of the status quo. History shows the folly of believing such statements by political leaders, because reality so often trumps their powers and good intentions. Mario Draghi, President of the European Central Bank, tempted the Fates with his speech at the Global Investment Conference in London on 26 July 2012. This might not look like sound thinking — or even rational planning — to future historians:

But the third point I want to make is in a sense more political. When people talk about the fragility of the euro and the increasing fragility of the euro, and perhaps the crisis of the euro, very often non-euro area member states or leaders, underestimate the amount of political capital that is being invested in the euro. And so we view this, and I do not think we are unbiased observers, we think the euro is irreversible. And it’s not an empty word now, because I preceded saying exactly what actions have been made, are being made to make it irreversible.

But there is another message I want to tell you. Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

Investors believed these promises, as they believed the larger implied promise of Central Bankers’ to produce modest growth and stability. Since the crash in 2008 markets have moved more strongly on the words of Central Bankers than on most economic and financial fundamentals. At times it seems as if Central Bank policy is the only fundamental, and external factors matter only in that they affect CB policy. It’s become the New Normal. It’s quite mad. Now reality might be striking back.

Nobody can reliably predict what comes next. Leave your preconceptions at the door. Whatever the result of these experiments, success or failure, economic policy management will change forever.

“Unless you expect the unexpected you will never find truth, for it is difficult to discover.”
— Heraclitus, the pre-Socratic “Weeping Philosopher” of Ionia.

Edge of the world
We’re sailing along the edge of the world. Art: “Final Frontier Voyager” by George Grie.

For More Information.

Posts about the big picture:

  1. Richard Koo gives a “Post-QE forecast: sunny, cloudy, or stormy?”, 26 March 2014
  2. Look at the economy. Fight the illusion of normality. Feel the weirdness., 8 October 2014.
  3. 2015 might bring an end to the great age of experts’ experiments on us, 30 December 2014.

Posts about the great monetary experiment:

  1. The World of Wonders: Monetary Magic applied to cure America’s economic ills, 20 February 2013.
  2. The World of Wonders: Everybody Goes Nuts Together, 21 February 2013.
  3. The greatest monetary experiment, ever, 20 June 2013.
  4. Do you look at our economy and see a world of wonders? If not, look here for a clearer picture…, 21 September 2013.
  5. Wagering America on an untested monetary theory, 22 January 2014.
  6. The easy way to understand unconventional monetary policy, 7 February 2014.
  7. Richard Koo gives a “Post-QE forecast: sunny, cloudy, or stormy?”, 26 March 2014.

Appreciate the wonders of our time.

"Machinery of the Stars" by alexiuss
Machinery of the Stars” by alexiuss at DeviantArt.
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8 thoughts on “Today began the next phase of the great monetary experiment, as reality plays a trump card.

  1. I am not yet ready to agree with the theory that the SNB has broken anything but themselves. This is a big event but not one that I can predictably say, “this IS the moment when the world changed.”

    That moment will occur when I think about what the US Federal Reserve can do in response to some event and say to myself, “they cannot do enough to fix the financial markets before things become terrible.”

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    1. After doing some more reading, I now agree completely with you. This isn’t the event that changes everything, it is the next step in the game of Jenga that reality is playing with the Central Bankers. We cannot know when the final move will bring the tower down but this event decreases the Central Banker’s margin of safety for the future.

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  2. In the same Zero Hedge post Grant explains that it’s life insurance companies that start complaining if rates are held too low for too long. Short term CB intervention is easily sustained by duration layering. Fixed income pros hold short medium and long duration bonds. Hiccups don’t matter to this average portfolio but over time a hiccup starts to become an asphyxiation. My point is not all ruling elites have benefited from CB policies. Powerful interests are quietly informing their CB policy wonks that it’s gonna be on like Donkey Kong between powerful players if their pain becomes life threatening.

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    1. Peter,

      Listening to Zero Hedge’s analysis will rot your mind faster than raw sugar will rot your teeth.

      Much of it is exaggerated, or framed in a misleading fashion. Some of it is outright wrong.

      I suggest you stick to summaries they provide from top research sources.

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    2. My bad. Should have realized your link was the real source. Changes nothing. Banks have prevailed so far. Max Keiser calls them suicide bankers for good reason. They strap the world financial system
      to their chest and shout “give us money or the financial system gets it”. Worked once. Credible threats usually do.
      The problem for the banks is now that threat is neutralized. Bank balance sheets are stronger here in the U.S. Now the problem shifts to fixed income. Pension funds. Public employee retirement funds. Life insurance companies.
      Over to you Jannet Yellin. Are you willing to buy equities? Oil?
      If not. The jig is up and insurance companies liabilities will exceed cash flows. This means forced liquidation of assets. This means debt deflation as per Irving Fisher. This means second Great Depression.
      I predict our Fed buys equities. Just like BOJ is doing now.

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    3. Peter,

      You are still relying on the Zero Hedge article for belief that there is a problem. You might as well get your info from the National Enguirer.

      “Now the problem shifts to fixed income. Pension funds. Public employee retirement funds. Life insurance companies.”

      Lower rates reduces their income from bonds over time, as existing bonds mature or are called and replaced by new ones at lower rates — and as new funds buy new bonds. On the other hand, the financial obligations of the institutions you list have long lives. So the managers have time to adjust. It’s a problem. But then there are always problems. High rates and high inflation are problems. So are low rates and low inflation. It’s all the material for clickbait to doomsters.

      “The jig is up and insurance companies liabilities will exceed cash flows. This means forced liquidation of assets”

      I assume you are kidding. Take a napkin and sketch out the flows to an insurer’s portfolio. Lower rates do not have large effects except over many years. Also the dynamics are far more complex. Rising rates can accelerate outflows (people seeking higher rates) at the same time the bonds in the portfolio are depressed in value. There are always challenges in financial management.

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