Thursday, 15 January 2015

Trust Me, I’m a Swiss Central Banker.

One trade structure I have always liked is the peg break trade. I first deployed it in 1997 with the Thai Baht. It is fairly simple and involves the option market pricing smooth curves of probability, thanks to nice models, over realities that are far from such. If I had had the confidence to put it on in EURCHF, or rather a lack in confidence in the Swiss national bank, then It would have looked a bit like this. Sell 1.2000 Eur puts Chf calls and buy twice as many 1.1750 or there about Euro puts choosing the period to make this 1x2 put spread at zero premium. The payoff being zero if no break but if there is to be a break I lose between 1.15 and 1.20 but make on everything below. The theory being that when pegs break they don’t mess around with 500pt moves instead jumping right over the loss zone into profit. This isn’t a bleat about missed trades, but an idea for future application and, more importantly, a lesson in faith.

Hands up. I had complete faith in what I was told by the SNB with respect to their attitude towards the everlasting floor. Wasn't it only a couple of weeks ago that the peg was held up as a cornerstone of policy? Why did I have faith in what the SNB said? Because removing the prop of central bank credence in the midst of a market that is completely controlled by central banks and the expectations of what they will do to save the world leaves a financial world orphaned. It's is a bit like hearing that your parents aren’t yours. If this faith is destroyed we have to question the worth of analysing Fed dots or every word from Draghi. Central bank policy has been working as much through words than actions, as has been clearly seen with the ECB and EU manipulating the Euro's bounce from the edge of doom in 2012 through threats of future actions rather than their implementation. However the SNB have effectively done for central banking what the Ferguson Police Department have done for community policing.

I feel betrayed and I feel confused. How could they do this to me? Am I fool for trusting them? Like that orphan I am searching for reasons as to why they made the decisions they did and questioning my own naive belief. There are times when you have to package up risk assessment into a bundle and put it in the drawer. You can’t live life unless you have trust in some of the building blocks. Time would be wasted in a dither and decisions never reached in time to act.

What was so important for them to deceive us and to threaten the very integrity of the cornerstone of Central Bank policy?

Let’s look at why the floor was put in place in the first place.

6th Sept 2011

The current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development.
The Swiss National Bank (SNB) is therefore aiming for a substantial and sustained weakening of the Swiss franc. With immediate effect, it will no longer tolerate a EUR/CHF exchange rate below the minimum rate of CHF 1.20. The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities. Even at a rate of CHF 1.20 per euro, the Swiss franc is still high and should continue to weaken over time. If the economic outlook and deflationary risks so require, the SNB will take further measures.

At that time the Euro was imploding and the CHF was seen as a Euro type currency but without the risk of Euro implosion and so CHF was seeing vast inflows as money sought a safe haven. The moves were indeed causing short term dislocations for Switzerland against its natural trading partners within the  Eurozone. The action was justified on this basis and combined with super low interest rates did indeed stem the flows and take the steam out of the run.

But the Swiss economy was and has been since, running a trade surplus against which, without the allowance of FX moves or recycling of those surpluses to adjust, has meant that even after the short term flood of safe haven seeking money abated the underlying pressure has been for CHF to strengthen. This constant has eroded any slack produced after defusing the Euro panic speculators and this in itself is a fairly good reason to question the floor policy.

But it has been the recent collapse in European growth and falling yields that has provided the latest wave of pressure. The SNB has been buying Euros at an increasing rate but unlike the 2011/12 panic there is little to see the pressure slackening without a rise in European yields. The opposite is most likely to occur with the ECB lining up to cut rates further. With EU QE a distinct possibility were the SNB really ready to stand in the way of a potential 1 trillion Euro of QE flooding against their dam? Faced with that it would make sense to step back, open the gate and wave the truck through rather than being mown down by it.

Another function is what the SNB have been doing with all the Euros they have been purchasing through intervention. Most of it is parked in bonds. Most in Euros, but the SNB has been diversifying reserves from the start. I can well remember the impact these diversification flows had on the likes of Aus$ and Swedish Krona as their first purchases were moved from Euro into diversified higher yielding currencies. Since then I have always had in the back of my mind the level of FX losses they must have been racking up as SEK and AUD fell and that these diversification would one day come home to haunt them.

Yet the SNB' latest figures show a profit of CHF38bio so something else has countered the FX losses (if they are taken into consideration at all). One only has to look at the performance of bonds, particularly the least risky Euro ones that they are most likely to hold (Bunds), to see where the plus side of the equation has come from. The SNB is in a fortunate position, being a central bank, of not having to mark its FX reserves to market so this has meant that intervening and parking the proceeds in bonds has provided a healthy profit. But the yield compression that has served them well now sees Bund rates negative out to 5 years, meaning that there is now a cost to parking the proceeds of intervention.

So the SNB have stepped back from an impending wall of Euro about to hit the market through QE and they are avoiding future costs in continuing the policy. Two further reasons to desist.

What of the SNB’s huge existing holdings of European bonds? Well, if they were to sell them all in a rush they would suffer moving the market against themselves. But the QE that threatens their floor through FX pressures is going to provide a massive bid for European bonds into which, should they chose, the SNB can hand their holdings painlessly, effectively passing the bond risk at very favourable levels from their balance sheet to the ECB's. Thank you.

How ironic if market positioning looking for the ECB QE to support their long Bund positions is usurped by the SNB filling the bid. Going forward the removal of the SNB floor has also removed a very strong bid in the European bond market and, to that matter, the likes of AUS and its other preferred diversification holdings. The end of SNB intervention will have a small part in increasing global yields as they desist from exporting negative rate pressures via their actions. Swiss negative rates will remain more Swiss.

To summarise the potential reasoning for the SNB removing the floor and in the process undermining all faith in their future commitments -

- The pressures on the CHF through real economic functions has mounted to a level to make the CHF no longer expensive at 1.2000
- To get out of the way of up to EUR 1trillion of EU QE.
- Yields are so low on their reserve holdings there is no cost benefit.
- EU QE will provide a bid into which to exit their existing holdings.
And let's add - Popular opinion in Switzerland towards the size of the SNB's balance sheet has made the whole policy a political hot potato.

There has been talk that they are preempting the risks to the Euro from a Greek Exit from the Euro. I would suggest that this is NOT a factor.

Nearly all of this reasoning premises ECB QE and with that in mind it is the strongest possible evidence that ECB QE is about to occur and central bank liaison has occurred. The cut in CHF repo rates could also been seen as an indicator as to where the SNB ( with maybe ECB help) have determined the effect of QE will drive effective rates in Europe to.

The lowering of rates to -0.75% on sight deposits to counter the tightening pressures of a stronger CHF is not universal though. It only applies to financial institutions and to amounts over a threshold. Whilst deposit rates are two tier in this manner negative interest rates can not be considered to be the actual interest rate consumers will experience.

If the general public were to receive negative rates on all their bank held funds one could assume that CHF1000 notes (yielding 0%) will demand a premium and the sales of hollow mattresses will boom.

The lesson is that if you peg yourself to someone else's monetary policy without the ability to recycle within a joint central bank then stresses to your own balance sheet will become intolerable in either extreme. If Switzerland had joined the Euro this would not have happened. This should be a lesson to all those considering currency pegs (including the Scottish National Party).

So where from here?  The first rush of CHF buying may well abate as the negative rates kick in and though we have seen EUR/CHF crater to 90 I would not be surprised to see a bounce, whether it is great enough for the SNB to start to reduce their balance sheet into is a harder call.

The effect on the street has been catastrophic. There would have been plenty of correlated trades crucified too and losses in CHF catalysing the closing of other positions as risk rules kick in as VaR models go into apoplectic spasms.

I imagine that senior managers have queues of 12yr old quants at their doors explaining how this wasn't meant to happen as their models didn't predict it.


aw said...

Great commentary. Thankyou.

Polemic said...

thanks aw. apologies if it repeats other's themes or is just plain wrong. Written off the cuff and haven't read any other commentary pieces yet.

Macro Man said...

One issue is that banks weren't quite dumb enough to sell anyone 1.20/1.1750 1 x 2's...I used to ask periodically and a number of banks wouldn't quote 1.20's, let alone anything below. Agree with most of what you wrote, however5- something similar from me tomorrow

Polemic said...

I look forward to it and trust it doesn't debunk most of my ramblings. See you back at the fort at tomorrow. <- follow this site everyone

Wes said...

or, because they are a lying, manipulative MFing CB...Roosevelt said give US your gold at $21 then revalued @ $35...same

CurmudgeonlyTroll said...

Not sure what the counterfactual is... are we saying they could have kept the peg unchanged in the face of ECB QE?

If not, what was the alternative? Re-peg at 1.10, you're just painting a target on your back for a one-way Soros-type bet by macro traders that 1.10 won't hold either.

The argument as I understand it is, in order to safeguard credibility, the CBs have to make a show of defending, and give the macro traders a metric shit-ton of free money for a little while so they can claim they put up a good fight... but I can't necessarily blame Jordan for thinking otherwise. Maybe you safeguard credibility by acting decisively when it's clear Plan A isn't working.

In fairness, I'm having trouble reconciling that 1) it was necessary because the flows into CHF from the more nimble macro guys, flight capital from Russia etc. were about to get out of hand, and 2) so many people were caught net short in big enough size to hurt them badly.

But anyway, macro guys make money by front-running and outsmarting CBs, so of course they're going to be butthurt when the CB front-runs and outsmarts them.

vlade said...

repost from NC, with some edits

You know, SNB made the right move in 2011 (when it put in the floor). They did IMO a stupid move now, and wasted time between 2011 and now.

Look at CNB (Czech National Bank), which one the only other CB with a floor, and now is the only one in EU. They put the floor, and then unexpectedly lifted it. That wiped out people who were willing to bet against it, and since then markets did the heavy lifting. Even now it's trading 3% above the floor (when people keep saying how a floor is indefensible..), and CNB's balance sheet moved little IIRC.

Of course, CZK isn't safe-haven currency, but you'd think that if there was an attackable position, smaller currency like that would be a prime target (not via options, but as MM says, you couldn't get anything in CHF, so it's passe)

SNB for some reason though that pidly 25bp would do something in December (reversed in about 3 days), and that more pidly 50bp would make it more orderly yesterday. Do they live in a cuckoo land? oh, wait.

The reasons they gave were dumb.

I could see how they would be worried about propping up EUR when/if ECB goes (what happens if it doesn't?). But there were at least two different options they could take even yesterday.

First option, they could switch the floor from EUR to USD. That means they would accumulate USD and the action in EUR/USD would likely depreciate CHF against EUR for free (markets would do the heavy lifting). US assets are also now easier to get than EU since Fed stopped QE (and Fed might actually like this...)

Second, they could slam in not pidly 50bp, but 500bp (which happens to be the implied tightening at the levels we saw yesterday BTW). I'm pretty sure CHF would see massive drop against EUR (which would give SNB opportunity to liquidate its EUR assets at a profit, while making the decline more orderly at the same time - what's not to like?). Then on day 2, when EUR is at 1.30, you can remove the floor saying it's clearly not needed anymore. Then, after ECB goes or not, you increase the rates to say -300bp and see what impact it has, and do the next step accordingly.

I feel really sorry for Swiss, as I have serious doubts of how many of their SME EUR exporters can now survive with their products being at 20% premia to start of this week. IIRC, more then 50% of Swiss exports are into EUR (I vaguely remember it could be as high as 80%), and if EUR demand doesn't pick up, and CHF appreciates as a safe-haven even more after ECB goes, Swiss economy is a toast.

Polemic said...

thanks Vlade. I'd support that but with regard to rates they would have to go negative to the general population, to the point where they could borrow at -ve rates. But at that point some very strange behaviour kicks in that drives the price of cash up.

vlade said...

@Pol: The deeply negative rates could have lasted week/two, before they would have got to a more reasonable level, not far from the current -75bp.

The point was that they needed to shock people who wanted to be long CHF, and shock them mightily, make it clear that holding CHF is going to be expensive in MTM or carry.

That's why I say they were wasting time for the last three years.

What they did yesterday was shoot their natural allies who wanted to be short CHF.

Anonymous said...

Some profitable advice, sep. 2014, for a long term play on the Swiss Franc.

(Grant's, September 19, 2014) Like a celebrity in flight from the paparazzi, the Swiss Confederation demands protection from its pesky admirers. To beat back the unwanted appreciation of the Swissie, the Swiss National Bank is--once again--vowing to move heaven and earth. Now under way is a speculation. Prompted by a friend (that's you, Harlan Batrus), we 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.