Central banks are losing their power

The Swiss National Bank not only roiled markets last week but potentially signalled the beginning of the end for the ability for central banks to calm markets.

"It might now be hard for some to take central bankers at their word."
Richard Yetsenga and Sam Tuck, Global Head of Financial Markets Research and Senior FX Strategist

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For one thing, it might now be hard for some to take central bankers at their word. SNB Vice President Danthine said the franc ceiling “must remain a pillar of our monetary policy” just last week. President Jordan said the cap is “absolutely central” for the Swiss economy on the 5th of January.

Markets had no reason to doubt these assurances. There was no theoretical limit to the SNB’s balance sheet and ability to maintain the CHF cap, and so it was taken at face value. However, the SNB has now blinked, presumably because it had become too uncomfortable with the balance sheet risk represented by a massive build-up in forex reserves.

This raises an interesting question of trust for the other major central banks who like the SNB have expressed “utmost determination” regarding their currency, such as the Bank of Japan. In similar circumstances to what the CHF/EUR previously held, the USD/JPY is abnormally positioned and unusually stable. For now.

Abandoning the cap: a summary

• The SNB had capped the price of the Franc against the euro at €1.20 due to instability in the Euro zone.

• Last week, it dropped the cap, citing greater stability and the cost of maintaining the exchange rate.

• As a result, the CHF (Swiss franc) rose 14 per cent against the Euro.

• The changes are likely to severely impact Swiss exporters and send ripples throughout financial markets.

It is clear this move was costly for the SNB, and as a result many are asking “why now?”

The 440bn CHF of reserves (suspected to have increased to close to 500bn CHF on this latest test of the cap) was over two-thirds of Swiss GDP. A simple calculation (ignoring reserve diversification) would suggest the SNB suffered a balance sheet loss of around CHF 60bn, or close to 10 per cent of Switzerland’s 2013 GDP, on the move.

Markets for now have concluded that the SNB felt unable to defend the cap in the face of European Central Bank quantitative easing expected this week.

Most importantly, central banks are finally being forced to relinquish some of their control over markets. This is not occurring for any altruistic reason. Rather it has just become a financially untenable position to maintain.

Richard Werner’s 2001 ‘Princes of the Yen’ decried the power of mandate-lacking central banks, particularly in Japan, and their ability to influence economic policy. This now looks certain to change.

More broadly, these policy changes highlight a few important macro-economic trends.

Firstly, relative monetary policy is shifting in favour of the US, but due to easing policies from other central banks rather than tightening from the Fed.

There is pressure on the Bank of Korea to ease its policy and lower rates (although it didn’t last week), cuts are expected in Australia, the Reserve Bank of India cut this week, the European Central Bank has a negative deposit rate and has now been joined there by the SNB, and we have recently revised our call for hikes in NZ.

Secondly, it implies the required tightening in the US is coming through the USD rather than through interest rates, and is likely continue to do so.

Both factors suggest that the global bond rally will persist for the mean time. Of course this thinking is also consistent with the view the USD is in a cyclical (and possibly secular) bull market.

In the short term though the corrective tone in currencies is likely to remain. USD/JPY is under some downward pressure, and it seems clear that the market has quite substantial short positions in AUD/USD. A position adjustment which drove the AUD higher would do little to upset what is becoming a well-established longer-term downtrend.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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