Switzerland Removes Exchange Rate Cap; Swiss Franc Skyrockets
Switzerland is one of the few European countries to avoid adopting the Euro and retain its own currency, the Swiss Franc. The Swiss Franc is heavily traded as a stable “safe haven” from the Euro, which is why recent abrupt action from the Swiss National Bank (SNB) caught investors by surprise.
Since the Euro has fallen, the Swiss Franc has appreciated accordingly, making Swiss exports more expensive and harming the Swiss economy. From the 2010 beginning value (1.47 Francs per Euro), the Euro slid to a low of 1.06 Francs per Euro by mid-2011. At that point, the SNB adopted a policy of capping the Franc against the Euro at 1.2 Francs per Euro, reaching and maintaining this cap through foreign exchange purchases.
Because of the Euro’s continued slide in world currency markets beyond 2011, Switzerland’s foreign exchange reserves have ballooned to over $500 billion. Given that the expected upcoming stimulus from the European Central Bank (ECB) was likely to drop the Euro even further, the SNB decided that this rate cap policy was not sustainable.
The SNB abruptly removed the cap last week – and like a tightly wound spring, the markets reacted with a surge in the Franc. The Franc surpassed the Euro, dropping to 0.98 Francs per Euro on Thursday and closing just below even value on Friday.
Fallout From the Flying Franc
Actions of the Swiss Franc predictably negatively affected Swiss company stocks such as Swatch (OTCMKTS:SWGAY) and Nestlé (OTCMKTS:NSRGY). The Swiss Market Index (SMI) took a quick 15% hit. International funds with assets in Swiss francs and hedge funds were also subject to wild adjustment, but the real action involved currency traders.
Currency traders were completely caught off-guard, and highly leveraged traders ventured near liquidation. FXCM (NYSE: FXCM), a large U.S. foreign exchange (FOREX) broker, found itself in a position of approximately $225 million in negative equity and was saved from potential insolvency though a $300 million bailout investment from Leucadia (NYSE:LUK)
Why Should You Care?
If you don’t operate in the leveraged currency market, why should you care as an investor? There are two main reasons: indirect and ripple effects of this action throughout the global market, and general concerns about the trust of central banks.
If any of your mutual funds hold a large position in Swiss stocks, the effect is obvious. However, the ripple effect took a toll on major banks as well. According to the Wall Street Journal, Deutsche Bank and Citigroup lost $150 million each and Barclays expects losses in the tens of millions.
Many mutual fund managers like to keep a 10%-20% portion of fund holdings in international funds to provide diversification. Investing in international funds by definition includes elements of currency risk. Do you know the underlying currencies supporting your international funds and whether they hedged against currency risk?
Meanwhile, the Swiss action is a classic example of what happens when central banks act quickly and unexpectedly. Much of the market is based on accurate predictions, trends, and expectations. A sudden shock can wipe out investors and companies in the short term and produce longer-term instability through lowering confidence in predictable moves.
Central banks exist to promote stability, not degrade it. Decoupling the Swiss Franc from the Euro makes sense, but by abruptly doing so without some warning to the ECB and the markets, the SNB did not allow time for a more gradual market adjustment.
For consumers, there are considerations as well. If the Swiss Franc rises relative to the US dollar – a possible ripple effect of it rising swiftly against the Euro – Swiss products become more expensive. It might pay off to buy that Swiss watch now, rather than later.
The adventures of the Swiss Franc remind us that it is always good to investigate the underlying holdings of your investments in some detail. Seemingly remote and unrelated financial actions can deliver a nasty surprise to your investment portfolio — or a pleasant one, for that matter — but it is important for investors to understand why.
Your portfolio must maintain a certain level of risk balance through diversification, and that is not always as simple as maintaining a stocks-to-bonds ratio or not pouring too many assets into alternative investments. It matters what type of stocks and funds you invest in, and with mutual funds it may require getting through layers to understand what you really own (and therefore the risk involved).
If you are an average investor, you probably were not affected much by the Swiss Franc appreciation. However, the reaction of other central banks and investors’ trust in their ability to predict that reaction may have further consequences.
For example, the Swiss Franc actions accelerated the drop in the Euro against the dollar (1.1561 at the Friday close, down from 1.1786 two days prior and continuing a slide from 1.2512 since December 17). If the ECB overreacts with the size of their stimulus package in reaction to the Swiss action, how would your holdings be affected?
You can find out now by investigating your holdings and making your own assessment on risk and opportunity, or you can find out later by checking your account balance. It’s your decision.