Losing Faith – Questioning The Latest Central Bank Moves

Imagine checking your brokerage account only to realize that your investment lost 88% of its value in just one day. That’s what happened with shareholders of currency brokerage firm Forex Capital Markets, better known as FXCM. As readers of the Daily Pfennig ® newsletter probably already know, the Swiss National Bank (SNB) decided last month to suddenly scrap a 3-year-old cap on the franc. The surprise move sent the Swiss franc soaring against the euro.1 Traders who had bet against the currency lost their shirt. And, that’s what almost brought down FXCM. The volatility in the euro/franc pair resulted in massive losses for the firm’s clients. As a result, the firm ended up with a negative equity balance, breaching regulatory requirement. The stock fell 88% in a single day.

If it wasn’t for a $300 million rescue package from investment bank Jefferies Group, the firm would have gone belly up. And, FXCM was far from the only party suffering big losses from this Swiss shock. Citigroup and Deutsche Bank both lost $150 million, while Interactive Brokers lost $125 million. But, behind this extreme currency volatility and the resulting losses, there’s a much bigger story, one that could have an impact well beyond the currency market.

Central Bank ‘Misguidance’
For me, the most interesting thing about this episode was how the SNB blatantly misled the market. You see, before all this happened, Swiss conservatives were worried that the SNB was taking too much risk by pegging its currency to the euro. After all, they had to buy massive quantities of European assets, including government bonds, in order to maintain the peg. The prospect of large-scale Quantitative Easing (QE) by the European Central Bank (ECB), together with the euro’s recent slide against the dollar, intensified the political pressure to abandon the peg. They even had a referendum to try to force the central bank to increase its gold reserves, which Swiss voters rejected.

In response to this increasing pressure, the SNB’s Chairman Thomas Jordan promised they would not break the peg. In a statement released just a few weeks before the de-pegging, he said: “The SNB remains committed to purchasing unlimited quantities of foreign currency to enforce the minimum exchange rate with the utmost determination.”2

And, just days before the announcement, which shocked the markets, SNB Vice Chairman Jean-Pierre Danthine continued to defend the 1.20 chf/euro stating, “the minimum exchange rate must remain the cornerstone of our monetary policy.”3 In other words, the central bank promised it would keep the peg on several occasions, leading everyone to believe them. But, this was just another example of what has become a fairly common scenario lately – a central bank giving a ‘head fake’ to the market.

And, it’s an important event because faith in central banks has played a key role in the past few years, especially in the equity market. Investors don’t generally like surprises – especially when they come from institutions that traditionally have stated a desire to be transparent in their actions.

Steering the direction of the major global economies is a tough job – actions typically take a long time to become results. If you have ever tried to steer a large water craft, you get what I mean – the reaction times are less than immediate. And, in negotiating today’s uncertain markets, central bankers have a need to enlist the help of investors in accomplishing their intended goals. This is exactly why they try to telegraph most of their moves. The central bank’s job of steering the economy is much easier if they have the help of the markets.

The Credibility Of Central Banks Is At Risk
We’re in the midst of the most unconventional monetary policies the world has ever seen. It seems that every time there’s a problem in the global economy, some central bank comes to the rescue with more “easy money” policies. As a result, there’s a near universal belief that if something goes wrong, central banks will step in with more stimulus. This is the ‘central bank put,’ which has caused equity investors to push valuations to near record levels and turn a blind eye to the increasing risks caused by what certainly look like over-inflated asset bubbles.

This confidence that central banks have the ability to control events has been a cornerstone of the bull market in stocks. It’s also a big reason why the U.S. economy appears to be strengthening. If that confidence evaporates, we could start seeing a lot more volatility in the stock market. Reuters recently pointed out that risk in a recent article saying: “The Swiss currency shock has raised an awkward question many investors have been fearful of asking: What if central banks become as unpredictable and fallible as they are powerful?”4

With this latest Swiss shock, from now on, investors may be more likely to question their faith in these central bankers. And, while this is bad news for the stock market, it could be good news for precious metals. As James Grant, editor of Grant’s Interest Rate Observer likes to say, gold is the reciprocal of the world’s faith in central bankers. In other words, a decline in central bank credibility could push gold higher. After all, fiat currencies only have value because of individuals’ faith in the government issuing the currency. Without this faith, the currency notes are worth just the paper they are printed on.

Gold Has Been Outperforming Equities


Source: StockCharts.com1
(Click here to view a larger image.)

In fact, gold jumped the day SNB removed the peg. And, it has been outperforming the stock market over the past couple of months, as you can see in the chart above.

The bottom line is the declining credibility of central bankers may create more volatility in the stock market. And, we could see more investors fleeing to the safety of gold in the coming months as trust in the leaders of central banks wanes. We have recently seen several of the major governments accumulating physical gold – with Russia and China taking the lead. And, in this case, it may be prudent for individual investors to follow their example, at least with regard to diversifying their portfolios.

I look forward to my next opportunity to address all of our readers in a future Daily Pfennig ® newsletter, and hope you “keep the faith” in the power of diversification.

Until the next Daily Pfennig ® edition…

Chris Gaffney, CFA
EverBank World Markets, a division of EverBank