16th January 2015 by Chris Iggo
Wow, Zurich is really expensive now – The power and influence of central bank engagement in financial markets was vividly illustrated this week by the decision of the Swiss National Bank (SNB) to abandon its policy of preventing the Swiss Franc from appreciating against the euro. The outcome is well known by now – a huge rally in the Swiss Franc, a further decline in the external value of the euro on a trade weighted basis, a move further into negative territory for Swiss interest rates and the emergence of stories of large losses in the foreign exchange market. This episode also illustrates the power of central bank policy in another way. It may be that the SNB decided to abandon the peg to the euro because it knows/expects the European Central Bank to announce a large QE policy in the next week and therefore wanted to avoid the overall external value of the Swissie being dragged down by further losses to the euro. Switzerland’s attraction as a financial safe haven would have been tarnished (especially to holders of dollars in the US, Middle East and Asia) if the Swiss franc was allowed to tumble with the Euro. So Swiss central bankers, acting in anticipation of Euro central bankers, announced a policy shift that saw arguably the biggest intra-day currency move since the collapse of the ERM in 1992 or the break-up of the Bretton Woods fixed exchange rate system. There were obvious spill over effects to bond and equity markets.
What is the maximum size for a central bank balance sheet? I think the SNB just told us – While the SNB’s policy did not constitute QE in the sense of how we think about it in terms of the Federal Reserve (Fed) or the Bank of Japan (BoJ), the policy of substantial intervention in the currency markets had the effect of massively growing the central banks’ balance sheet to something close to 85% of Swiss GDP (not even the BoJ is quite there yet). Thus while the decision to abandon the peg might have been driven mostly by considerations of the impact of a weakening euro on the Swiss franc itself, some concern about the size of the balance sheet and the over-extension of the Swiss monetary base as a result of that intervention may also have played a role. If there is any concern about allowing central bank balance sheets to grow to represent very high proportions of GDP this might make it difficult for the Fed and Bank of England (BoE) to re-start QE at some time, if that became necessary. The Fed, BoE, BoJ and ECB’s combined balance sheets already account for something like 10% of global GDP. A piece of research today stated that over 50% of the US Treasury market is owned by the Fed and other foreign central banks. It has always been the case that central banks have played a very important role in determining financial market prices through their control of official interest rates and their currency policies but today they own financial assets like never before.
Pay someone to borrow money from you! – Another aspect of the SNB story is the decision to make short term interest rates even more negative. This is intended to dissuade people from holding Swiss franc cash at the central bank, but it is also transmitted to money market rates to try and achieve the same thing. Negative interest rates are becoming more common in developed economies in both money markets and bond markets. We now have negative yields at the short end of the euro core government bond yield curve and in Japan, as well as in Switzerland. We are entering a world with more and more examples of creditors having to pay for the privilege of lending money. What is this telling us? It tells us that the financial markets are awash with liquidity as a result of unprecedented intervention by central banks in domestic bond and foreign exchange markets. It tells us that there is still an insufficient demand for credit. It might be telling us that monetary policy is still not working. Banks and other participants in the money markets are willing to pay others to take cash off their hands. Central banks are penalizing banks from holding cash in their central bank reserve accounts but there are not many opportunities to put that cash to work for a positive return in the markets or in the real economy. Regulation is prescribing what assets banks can hold and how much capital they need which is preventing a resumption of lending, even if there is some improvement at the margin. Investors face shortages of assets that provide a decent return and the ECB is about to embark on a policy that will try to dislodge those assets that are held in private hands. Imagine you had bought a French government bond (4.25% 2018) at launch in 2008 and held it until now. The total return would have been tremendous so far but now it trades at a price of 116 and has a yield-to maturity (3.75 yrs to go) of -0.028% (according to Bloomberg). The ECB wants to buy it from you as part of its QE programme but you need to be invested. If you sell it, what do you do with the cash that you receive? As a liability or cash-flow matching investor you need something that has the same maturity. Why bother selling the bonds? To get a better yield from the re-investment you would need to take on more credit risk. Some investors will be able to do that, others won’t. Imagine if it had been a corporate bond with the same life. The yield numbers would be higher but selling it today and re-investing for an attractive yield would mean going in to sub-investment grade. Moreover, there is a general shortage of fixed income paper and, what there is, is very expensive. So consider this. Why not invest in money markets? Yes, you will get a negative return but you could get an even worse negative return in 3-year paper with a 0% yield and a duration of 2.5yrs or more. It only takes a modest tick up in market yields to generate a total return loss. It’s not what the design of QE had in mind for money to stay very short duration, in money markets, and not go into “risk” assets. Scarily though, that is what current market dynamics suggests might happen.
Labour had a “Third Way”…what about the “Iggo way” – Negative money market and short term fixed income yields suggest a failure of monetary policy or a policy that has reached its limits. QE is backdoor financing of budget deficits so why not be upfront about it. If I was prime minister (I know, it’s not going to happen but…) I would argue for a massive programme of public spending and tax cuts, financed by borrowing long and at historically low interest rates. Not only would growth be boosted but there would be long term assets that would satisfy the demand for such long-term assets from investors – especially if they were index-linked so real returns would be somehow protected. There’s a lot of spending that could be done on roads, railways, housing, schools and hospitals. And there are lots of taxes that could be cut to boost confidence and spending in the corporate and household sector. Central banks have created the liquidity but there are not enough assets that fixed income type investors can put cash into. Create new assets then. Ones that are linked to long term economic growth. A 60-year bond with a nominal GDP linked coupon issued by the government would be attractive to investors even if the starting coupon was extremely low in line with current market rates. The government would raise cash, be able to boost the economy through fiscal policy and have a liability that was linked to the future growth of the economy.
There’ll be fewer snowboarders in Verbier this February – In the absence of something like that I fear that 2015 is going to be a horrible year (according to some anecdotes, the year has ended already for some market participants). Big price adjustments like the Swiss franc and the dollar price of a barrel of oil might become more common. Even if the macro data is telling us growth is relatively stable, this might not prevent a big adjustment in equities, or in high yield or emerging market currencies. Yields are extremely low, the ECB is perhaps going to print €600-800bn of liquidity. The financial system is already awash with cash and is having to pay to hold it. This doesn’t seem like a stable situation. Perhaps we were too early in calling for an inflation problem as a result of QE but you never know. The worst thing is that this might all be a result of policy actions and not economic imbalances. Perhaps we just need to learn to live with low-flation. We all stressed about Japan for the last 20 years but if you look at the per capital evolution of GDP in Japan it was pretty much identical to that of the US, just that Japan’s population was shrinking. We are not in a particularly bad cyclical position – there is no mass unemployment in the US, UK or Germany. Yes, income growth has been non-existent and the distribution of income has become more uneven, but western economies are generally wealthy and comfortable if moribund. It’s just we are not used to this situation of microscopically low interest rates and we don’t understand what the longer term implications of nanny-state central banking have been or what it means when they get stopped out. Let’s go all the way and monetize some growth and reflation. It might set up some conditions for wealth creation again. Boosting economic growth through long term borrowing is not a crazy idea is it? It just needs some imagination and for central bankers to be ready to turn off the taps again once real exit velocity has been reached. Surely it’s been done many times before. There has to be something to be done so that we can afford to go skiing in Switzerland again. Would this get me into Number 10?