Last year when the ECB broke the taboo regarding major Central Banks moving rates below zero, it was novel. Never before had a major Central Bank moved rates into negative territory. However it was a little like trying pot in college. Or how your wife admitted that she once made out with another girl at a party on a dare. For sure it was outside the realm of a typical night out, but it was hardly the stuff that was going to shake the world. After all, the ECB only ventured 25 basis points away from the zero bound.
However yesterday the Swiss National Bank ventured out of the experimentation phase and decided to move into the hedonistic crack shack in the seedy part of downtown. With yesterday’s SNB move to negative 75 basis point overnight rates, the zero bound has been thrown out the window.
Everyone is focusing on the massive currency volatility in the Swiss Franc, but I think the move to negative rates is an equally big story and is getting missed in the excitement of the move in the Swiss Franc.
As the world’s major economies have suffered from the bursting of various credit bubbles, they have often found themselves constrained by the zero bound on their short rates. Japan’s overnight rates have been basically at zero since 1998. When the credit crisis of 2008 hit, the Federal Reserve also found themselves needing a short rate that was below zero. The US overnight has been zero for the last five years.
Up until last year, the answer to the problem of needing a short rate that was below zero was either for the Central Bank to commit to a zero rate for a period of time (forward guidance) or for the Central Bank to engage in quantitative easing by expanding their balance sheet through the purchase of bonds. There was a belief that you could not push rates into actual negative territory because the financial system was not designed to deal with negative rates. Therefore as a Central Banker, you were forced to find other ways to ease when you were confronted by the zero bound.
The Swiss National Bank has just nominated their country to become the guinea pig in a massive experiment about not being constrained by the zero bound. Think about this move for a second. They moved to minus 75 basis points. Why can’t they go to minus 200? Or minus 300? Once you have accepted that zero is no longer a bound, it opens up the door to any sort of rate.
And take a moment to really think about what this means to other countries’ overnight rate. Japan has been stuck at zero for decades. They have been desperately expanding their balance sheet to try to make inflation. But the risk is adding up, and some of the Japanese politicians are getting nervous. Not only that, but all of a sudden their overnight rate has become relatively tight. Euro overnights are minus 25 basis points, Swiss are at minus 75 basis points. Japan’s minuscule overnight is positive carry! Why shouldn’t Japan also push their rate to negative levels?
Let’s not forget about the ECB. They were the ones that broke the taboo in the first place. Could the Swiss be simply front running a big move from the ECB towards even more negative rates? The ECB is more constrained than many other Central Banks about their ability to execute large Quantitative Easing programs due to Germany’s insistence about not monetizing the government deficits. Therefore it would make sense that the ECB would be more willing to venture even further into negative overnight rates.
This move by the Swiss National Bank is game changing. Make no mistake about it. We need a new rulebook.
Have a look at the chart of the 3 month EuroSwiss contract for March 2015.
The idea that the short end is bound by zero has been blown out of the water.
If the EuroSwiss 3 month contract trades at 100.69, why can’t the European 3 month contract also climb above zero? Have a look at the Euribor contract for March expiry.
I am taking a stab at the long side of the Euribor futures market. I think that there is a decent chance that the ECB is going to push their rates into negative territory. Everyone is busy shorting euros to try to capitalize on the coming ECB easing program, I think long Euribor is a better risk reward.
Volatility is going through the roof – and that’s not a good thing
There can be no denying that yesterday’s move in the Swiss Franc was a historic event. Everyone knows the famous story about when Soros broke the Bank of England. I have created a chart that compares the two moves.
The move in the Swiss Franc was larger, and more importantly, it happened all at once. The pound crisis happened over a period of days. The unravelling of the Franc peg was an almost instantaneous affair.
I can’t stress this next point enough. Financial participants have mistakenly assumed that reassuring market price action over the past few years signifies that there is little to be concerned about. But yet, up until yesterday, the EURCHF looked like one of the safest (and most stable) investments out there.
The SNB’s failed attempt to peg their currency is analogous to the world’s Central Bankers attempt to manipulate higher all financial assets. It seems to work until it doesn’t.
Market participants have become convinced that these asset prices are “right.” But they forget who was the biggest driver of these moves.
Do you really think that this chart of the S&P 500 vs the Fed’s balance sheet is a coincidence?
And then, do you really think the Fed is going to be there to prop up stock prices on the first dip?
Recently the Fed has been abundantly clear in attempting to convince the market that it won’t be held hostage to the vagaries of each downward tick in the S&P. From Bloomberg:
When Fed officials met in October, two weeks after the Standard and Poor’s 500 Index (SPX) wiped out all of its gains for the year, they discussed adding a reference to market turmoil in their statement. They rejected the idea to avoid the “misimpression that monetary policy was likely to respond to increases in volatility,” according to minutes of the meeting. **”Let me be clear, there is no Fed equity market put,”** William C. Dudley, president of the New York Fed, the central bank’s watchdog on financial markets, said in a Dec. 1 speech in New York. “Because financial-market conditions affect economic activity only slowly over time, this suggests that we should look through short-term volatility.”
All financial markets are showing increased volatility. Volatility is usually a bad sign. Bull markets chug steadily higher with little up and down movement. When things start zinging around, it is a sign to head to the sidelines.
I am still short S&Ps, and although we are approaching levels where I would usually be ringing the register on the position, I am hanging tough. The world is becoming more and more scary. This is not the time to be betting on this uptrend to continue.