For three months, the financial world has latched on to taper worry. Just the thought of doing less than $85B in monthly Federal Reserve bond buying brought major consequences upon U.S. markets.
Now, imagine this. One day, not so far away, flows don’t just fall off. They shut off entirely. There will be a huge pile of bank reserves sitting in the Fed.
What will the Fed do?
Central bank interventions have been done all over the map these last five years. In one place, Switzerland, a debate on how to unwind a huge pile of central bank reserves is at an advanced stage.
Dissecting the Swiss exercise is very instructive. It helps us to learn about the policy tools. And the consequences to unwinding the massive pile of U.S. safe haven capital parked inside the Fed and elsewhere. The U.S. economy and its stock market must manage its way through this for years.
The Swiss Background
Back in 2008, the amount on offer for a single Swiss franc sat at 1.60 Swiss francs per euro. Then, rounds of Euro area banking and fiscal crises set upon the Swiss currency, and its stable and well managed banking system. Safe haven capital piled into Switzerland; much as investors piled into safe haven U.S. Treasuries.
At the peak of the first Greek crisis, the exchange rate reached 1.00 Swiss franc per euro. This expensive price on the major Swiss exchange rate cross was seen briefly, in a fall spike, in Sept. 2011. Portfolio capital was being parked in a safe haven at the center of Europe.
That led to the decision to impose a ceiling on the Swiss franc. The ceiling was set at 1.20 Swiss francs per euro. The Swiss National Bank (the SNB) managed to maintain that level religiously in 2012.
To drive the Swiss franc back up from the 1.00 to 1.20 level, the SNB bought literally hundreds of billions (in U.S. dollar terms) of foreign currencies. This kept its small open economy from collapsing under the weight of a deeply overvalued currency.
In the face of one euro area crisis after another, the SNB kept on buying. The currency manipulations caused SNB foreign exchange reserves to bloat from $100B U.S. dollars at the end of 2010 to more than $470B in July 2013.
A financial buffer is needed in any banking system to insure against financial turbulence. But an amount of foreign currency reserves of 75% of Swiss GDP is another matter entirely.
On May 22nd, with U.S. taper talk lifting bond rates there, the Swiss franc slithered its way to 1.2648 Swiss francs per euro, its lowest level in two years. Thomas Jordan, the head of the SNB, spoke of further action to weaken the Swiss currency (up to 10% more) and tackle Swiss deflation.
Into 2013, the imposed 1.20 Swiss francs per euro ceiling barely held off deflation. Swiss consumer inflation looks set to remain just below zero in 2013. The producer price index (the PPI) in Switzerland averaged +0.60% per year over the last ten years. In the Eurozone, it has been +2.85%.
Swiss Policy to Reverse the Safe Haven
Reversing a huge financial intervention of any sort has risks. Safe haven reserves offer zero returns to those parking money. They are highly liquid. This exposes the Swiss economy to a possible major currency move, should Swiss policymakers decide to help unwind these FX positions. Nobody expects the U.S. currency to have a similar problem, but imagine if it did. Chaos would result.
One proposal to kick-start the Swiss economy? Impose negative interest rates on its massive pile of central bank reserves. Such a policy curbed speculative capital inflow in Denmark.
A second proposal? Reduce the exchange rate ceiling further, from what is currently set at 1.20 Swiss francs per euro. Announcing parked money will be worth less will get it out of there, and get Swiss exports moving faster.
Paying too much for parking is nothing new. I am sure all of you have done it, and then walked or biked next time.
At this point, think thru the blowbacks. Charging banks to park money with the SNB may take the steam out of an overheated Swiss housing sector. Added costs could be reflected in more expensive mortgages. A similar fate may fall upon a wide range of Swiss consumer and business loans.
The Weekend’s Real Time Insight Debate…
First of all, do you think the Swiss kick-start their economy by reducing the pile of safe haven capital? Or will they blow it, by not understanding the unintended consequences in their decisions?
Second, can the U.S. learn anything from this? What policy tools do you expect the Fed to use to take down its $3.5 Trillion pile of reserves?
Does the pick of a new Fed chairperson matter here?
Finally, what happens to U.S. stock and bond markets, while this huge U.S. stock of capital reserves melts? Much like the Swiss case, will U.S. housing market momentum suffer?