Last week the Swiss central banking authority shocked global markets by abruptly removing their exchange rate cap to the Euro, resulting in a 20% overnight increase in the value of the Swiss franc vs. the Euro. 1 franc now purchases 1 Euro.
The cap started 3 years ago, when Switzerland drew a line in the sand at 1.2 francs to the Euro. It was done in an effort to protect Swiss exporters, which had an increasingly difficult time selling to European countries. In 2007, 1 Euro bought almost 1.7 francs. The cap went relatively smoothly until concerns about the Euro flared up during the second half of 2014, and speculators increasingly bet the cap would fail. In December 2014, speculators bought 38.5 billion francs - roughly 10 times average monthly fund flows (according to Reuters).
The chart above shows the value of the Euro falling against the franc.
After releasing the 1.2 cap, the Swiss central banking authority set the interest rate at negative0.75%, in an attempt to discourage further appreciation. As global interest rates remain stubbornly low, watching Swiss rates go negative is not an encouraging development. However, this is better for the Swiss than giving taxpayer cash away while trying to hold onto a 1.2 exchange rate.
On the day the Swiss central bank capitulated, the percentage move was astronomical in a market where traders (amateur and professional) use massive amounts of leverage. The revaluation caused the instant collapse of a few foreign exchange brokers. I suspect that global markets shook mainly due to concern about how the speculation prone megabanks were exposed. Based on the relative calm since the initial volatility, it seems like not too much. If the financial sector can make it through unscathed, this shouldn’t have much effect on the global economy.
Watching Swiss interest rates go negative is a reminder of the importance of a diversified approach. In the US, some investors stopped buying bonds when the 10-year fell below 3%, due to expectations that rates had nowhere to go but up. And yet bond yields kept falling (the 20-year iShares bond fund TLT was up 27% in 2014). Market timing remains speculation, as no one knows what the future will bring. Bonds typically perform best during periods of deflation (e.g. during a recession).
Watching the Swiss cap break and move 20% in a day is a reminder that artificial exchange rates have risk, even as central bankers assure people otherwise. Swiss companies and individuals with the majority of their expenses in francs, but holding large positions in Euro were hurt by this revaluation. Some probably held excess Euro out of complacency, but sometimes people actively speculate on artificial rates. For the past 10 years or so, people have piled up RMB thinking it could only go up against the USD. Even when it feels like a sure thing, risk is involved.
And watching the Euro’s drop over the last 6 months is a reminder that holding large positions in a currency you have no real need for is a gamble, not an investment. For your cash and fixed income investments, we recommend focusing on currencies you need for everyday spending and long term goals. Most investors can achieve a good amount of currency diversification through an internationally diversified stock portfolio.
Learn from the Swiss franc revaluation - use a diversified approach, try to match investments to future liabilities, and manage your risks appropriately.