Note from Harry: I misstated a few points in yesterday’s Economy & Markets, which I wanted to correct. More importantly, this topic is a particularly important one for you so I want to make sure you read it. If you haven’t read it yet, you can do so now. And if you have read it, please glance at the correct article below.
The markets have had an array of abrupt reactions to the Swiss National Bank’s (SNB) move to stop supporting the Swiss franc against the euro from buying Swiss bonds.
But the biggest impact is likely to be on Mario Draghi’s up-and-coming decision to ignite another heavily telegraphed round of quantitative easing (QE) to the tune of $1.2 trillion plus.
But I’ll get back to that.
Few people realize that Switzerland, even more so than Japan, has been the most aggressive at QE and at expanding their central bank’s balance sheet by five times since January 2008.
Why would the normally conservative Swiss bank be so aggressive in stimulating and then reverse so sharply?
The Swiss like most European nations are big exporters, at 50% to 54% of GDP since 2006. Switzerland’s largest trading partner is the euro zone economic bloc at 40%. A falling euro versus the Swiss franc hurts Swiss export industries from watches to chocolates. As the euro weakened against the franc from late 2007 through August 2011, Swiss exports were getting crushed because euro zone clients couldn’t afford them.
The pain became too much for the Swiss in September of 2011, at which point the SNB announced it wouldn’t let the franc appreciate any further against the euro, they would hold the line at 1.20 francs per euro.
To do this, the Swiss had to continually print francs to buy euros whenever the exchange rate tried to go below that level. Switzerland was David fighting Goliath. The chart below shows the euro versus both the Swiss franc and the U.S. dollar since 2007.
The flat section of the red line from 2011 until last week is where the Swiss held the franc/euro exchange rate at 1.20.
The euro peaked against the dollar in March of 2008 at 1.60. I remember that painfully as I was in Italy at the time paying top prices for everything. The euro has devalued 28% against the dollar since then.
But there is one big difference for the Swiss. Their largest industry is global banking and a falling currency means affluent depositors lose value… they don’t like that!
By pegging it to the euro, foreign depositors, whose home currency is the euro, are neutral — but as the euro lost value compared to other currencies, the franc fell against other currencies as well.
This meant that foreign depositors outside the euro zone lost value.
So, the Swiss couldn’t afford to single-handedly keep fighting the euro since it meant they were fighting almost every other currency at the same time… and its banking sector needs to return to the safe-haven status it’s always offered, especially now that it has had to give up much of its secrecy advantage.
The euro zone is heavily split over Draghi’s intention of strong QE. Germany and the other healthier northern countries — Austria, the Netherlands and Finland — are against another desperate round of QE.
Yes, that would benefit their exports, but they’re doing well enough to value the long-term over the short-term benefits of desperately taking more financial drugs.
The Mediterranean countries are all flagging — France, Italy, Spain, Greece and Portugal. They desperately need escalating QE to keep their bond rates low (with the strongest rising deficits) and to continue to stimulate their exports and trade imbalances.
Here’s what’s so important about the sudden Swiss move: the SNB just preempted Draghi.
The euro is falling without further QE as a Swiss withdrawal of that move is like an increase in stimulus for the euro. If Draghi adds insult to injury with a big jolt, the euro could be at parity in short order to the U.S. dollar.
Given that there is already a big rift over such QE, it makes it harder for Draghi to follow through — at all, or as strongly, as he has telegraphed.
Anyone that doesn’t think that European and global stock markets will tank if Draghi doesn’t follow through is nuts.
The continued fall of the euro only adds to the rising dollar trend that is a wrecking ball for the commodity collapse that keeps hitting emerging countries and their debt exposure, not to mention the fracking bubble collapsing.
The markets know that they can’t keep going up without continued QE. The U.S. is on hold for now, Japan is off the reservation on the excessive side. The ECB is the only major region that can keep upping the ante here.
The U.S. is the only market holding fast to the delusion that we’re at escape velocity and more QE is not needed. That will change in 2015 when our economy unexpectedly slows due to demographic trends, as will Germany’s and many others in Europe.
Germany has been leading the protest against the new surge in QE. A court just approved more QE and defined it as legal up to a point, so Draghi won that round.
Draghi is going to have to announce some QE at the ECB meeting on January 22 or face great disappointment by the markets.
But what if Germany is successful in blocking QE down the road or keeping it more minimal?
That broader decision is due around March, just when we have the strongest potential turning point in this year’s cycles.
A balk on European Central Bank’s QE and continued falling oil prices are likely to be the two triggers for the next global stock crash… and they are, of course, intertwined.