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Financial markets were rocked on Jan. 15 when the Swiss National Bank surprised the world by removing its three-year cap on the Swiss franc/euro exchange rate.
Most U.S. investors probably pay little attention to the arcane movements in currency markets. There, prices are driven by factors such as domestic and global economic conditions, interest rates, central bank policy, and, of course, sometimes by irrational crowd psychology.
The seeds for this latest currency debacle began back in 2011 when Europe was reeling with the debt problems in Greece. As a result, money poured into Switzerland seeking a safe haven. Now, you might think that gobs of money coming into your country is a good thing. However, too much money flow actually can destabilize an economy.
This financial flight to safety sent the value of the Swiss franc soaring, causing problems for Swiss companies like the luxury watchmakers and others who depend on exporting goods. The high value of the franc raised the price of Swiss goods to consumers in other countries, hurting their sales.
So, in the summer of 2011, the SNB announced a cap on the exchange rate between the euro and the franc that would not let the euro fall below 1.20 against the franc. The SNB managed the cap by printing francs and buying euros. The strategy worked until, inexplicably, the bank removed the cap.
In an instant, investors woke to the news that the franc soared over 40 percent against the euro and more than 15 percent against all 150 currencies tracked by Bloomberg. The dollar rose to an 11-year high versus the euro.
Sure enough, a few brokerage firms that specialize in foreign exchange trading and that cater to individual investors failed, wiping out many small investors. Worldwide, an estimated 4 million individuals trade currencies accounting for 20 percent of the average daily trading volume. Europe has no caps on the amount of leverage an investor can borrow for foreign exchange trading, and it is not uncommon to reach 100-200 times your account balance.
Many are puzzled why the SNB made this move, but it is likely the bank got nervous defending the value of euro, especially considering the European Central Bank is on the verge of a major quantitative easing program.
Bond markets around the globe are registering record-low interest rates. In Switzerland and Germany, some government bonds have bizarrely turned negative, meaning investors are paying governments to borrow money.
This event demonstrates that markets are still adjusting to the weak European economies and fears of global deflation. There are implications for the United States, too. Interest rates in our bond market continue to drop—partly due to a flight to safety in the U.S. dollar and from deflationary price pressures like the huge decline in oil prices.
All of this puts the Fed in a difficult position. Can it begin raising U.S. interest rates when the rest of the world is fighting deflation? The United States is still the best house on the block. Yet investors shouldn’t ignore the forces swirling around our neighbors.•
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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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