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Efforts are underway to undermine Switzerland's rock solid reputation as
a safe haven. The alpine nation, famous for its readiness against enemies
with citizens storing military assault rifles at their homes, is under
attack. The attack, however, comes from one of their own, the guardian of the
Swiss franc: the Swiss National Bank (SNB). In any other country, a central
bank may have the power to derail the currency; in Switzerland, however,
efforts to undermine the franc may be more appropriately characterized by a
Don Quixotian battle by a lone warrior, a warrior armed with a license to
print money.
Prices, be they for goods and services, stock prices or currencies, are
best set by free markets. The euro and the Swiss franc are traditionally two
highly correlated currencies; however, there are rational reasons why each
currency has periods of strengths and weakness. SNB Chairman Philipp
Hildebrand does not appear to see it that way; he was on a mission against
"speculators" that gauged the Swiss franc to be a safer place than
the euro. As his influence rose in early 2009 (his promotion from Vice
President to Chairman was announced in early 2009, but did not take effect
until early 2010), Switzerland began to intervene in the currency markets,
apparently with the aim of pegging the Swiss franc to the euro. Below is a
chart of the Swiss franc versus the euro over this time period (a rising
trend reflects Swiss franc strength versus the euro); sharp moves downward
tend to coincide with larger interventions to "punish" speculators:
As the Greek crisis intensified, it became ever more difficult for the
SNB to achieve its goals. It appears to us that investors scared of any
fallout from Greece were treated as enemy combatants for seeking refuge in
the Swiss franc. It is mindboggling to brandish those diversifying from the
euro to the Swiss franc as speculators. Without a doubt, the Greek tragedy
made the euro appear riskier to rational investors. There's a perception at
the SNB that a strong Swiss franc versus the euro hurts Swiss exports - the
SNB prefers to use the more dramatic and over-used term deflation. On the
margin, that may well be true, but consider:
- Switzerland's strength has never been to compete
on cost. Keeping a currency weak for competitive reasons is something
stronger Asian countries may be in the process of relaxing because these
policies may have caused inflationary pressures to build.
- Swiss firms have extensive experience in dealing
with fluctuating exchange rates, as well as a strong Swiss franc.
- Swiss multi-nationals generally have foreign
subsidiaries through which currency exposures of revenues and expenses
can be more easily aligned.
- Swiss watchmakers are complaining because of the
high price of gold, not the strong Swiss franc. Indeed, a stronger Swiss
franc would alleviate some of these additional cost pressures.
- Most importantly, Swiss banks depend on the trust
in the Swiss franc. It's bad enough that Swiss bank secrecy has more
holes than Swiss cheese. If the SNB were to succeed in actually
weakening the Swiss franc in a meaningful way, the confidence loss in
the banking industry may easily exceed the short-term benefit of
boosting exports.
Axel Merk's book, Sustainable Wealth: Achieve Financial Security in a
Volatile World of Debt and Consumption is available now.
In early 2009, before the first interventions took place, we wondered how
effective such a strategy could be. When Japanese policy makers make threats
to intervene to weaken the yen, we take them very seriously; after all, the
Japanese might be willing and able to destroy their currency in a possibly
fruitless effort to boost their economy (see our January 2009 analysis Yen's Kamikaze Flight Trajectory). But the Swiss?
Would the SNB go all the way in their effort to weaken their currency? Our
judgment has been that it is unlikely; history so far seems to prove us
right. However, because of the disconnect between the talk and action, the
Swiss National Bank's policy is not fighting, but encouraging speculation.
Each time the SNB intervenes to weaken the Swiss franc, it may be a gift
to speculators, as they can buy the Swiss franc at a discount.
It's not just cultural reasons why the SNB is unlikely to succeed on a
"kamikaze mission": Switzerland's public finances are too sound
to be easily wrecked by a rogue national bank. While Switzerland's
debt-to-GDP ratio is reasonably low by international standards, the country's
discipline slipped during the 1990s; during the period, the gross debt-to-GDP
ratio (including federal, cantonal and communal debt) rose from 31 to 54
percent; during the same period, Ireland, Portugal, Belgium, Netherlands and
Denmark all reduced their debt-to-GDP ratios (source: 2002 IMF Working Paper on Swiss Debt Brake). As
Swiss debt-to-GDP ratios climbed, a movement in Switzerland was born that
eventually led to a constitutional amendment that requires a balanced budget
over a business cycle: the balanced budget amendment, commonly referred to as
the Swiss Debt Brake, was passed in 2001 and implemented in 2003. Without going
into the details of how the mechanism works, relevant for our discussion is
that the will of the voters imposed fiscal discipline.
There is a very real consequence of a country living within its means:
the debt market of that country is not very large. The Swiss debt market is a
rather quiet one: investors often buy debt at auctions, then hold them to
maturity; since the onset of the financial crisis, Swiss T-Bills have often
been auctioned off at face value, meaning buyers get 0% interest for lending
their money (or negative interest after commission). In such an environment, quantitative easing or credit easing is more easily said than done: the
SNB cannot print money to buy Swiss debt on a grand scale as there are simply
not enough sellers around. However, never underestimate the creativity of
central bankers: if it is not realistic to buy Swiss franc denominated debt,
why not use the Swiss central bank's balance sheet, i.e. print money, to
buy euro denominated debt? An intervention strategy was initiated that
allowed Swiss-style quantitative easing, currency intervention, all in the
name of fighting deflation and speculation.
Except, that the SNB gamble has not worked. As a result of buying euro,
well, the Swiss National Bank's balance sheet, now holds euro - lots of it;
indeed, the SNB now holds significantly more euro than Swiss francs. The SNB may
be running out of ammunition as it has a dwindling supply of Swiss francs;
theoretically, that should not stop a central bank: indeed, the SNB can
create Swiss francs out of thin air (a mere keyboard entry into its accounts)
to buy euros. However, politically, it will be an uphill battle for the SNB
to claim it is pursuing its Swiss mandate should they almost exclusively hold
euros.
Unlike other central banks, the SNB is a publicly traded corporation with
shareholders; the Swiss federal government is not a shareholder, but the
cantons are; theoretically, anyone can buy shares, subject to availability.
While the SNB's corporate charter has certain special features, most
importantly the power to print money, heavy foreign currency exposure may
create wide swings in earnings; notably, the SNB may report losses in the
billions as a result of its currency interventions (that may turn into
substantial profits if and when the euro recovers). While even a negative net
worth is mostly a technicality for a central bank, most damaging about such
losses is the wrath of the public that may scrutinize the bank in more
detail. Swiss citizens have shown that they can impose discipline on fiscal
policy; they may very well rein in a SNB not fulfilling the will of the people.
So what is an investor, rather than speculator, to do? In a March 2009 op-ed published in the Financial Times, we
cautioned Switzerland may cede its safe haven status to Norway. While we
gauged at the time that the SNB's policies would not lead to its desired
long-term devaluation of the Swiss franc, we did anticipate a more negative
investment climate for Switzerland as a result of the more activist central
bank. We are on record for shifting substantial assets from Switzerland to
Norway from early 2009. We started to reduce that position as the SNB's
position became increasingly untenable. Below is a chart of the Swiss franc
versus the Norwegian krone (a downward trend reflects Swiss franc weakness
relative to the Norwegian krone):
In our assessment, the biggest problem with central bank currency
intervention is not whether it is effective or not, but that investors start
focusing on possible intervention rather than underlying fundamentals. While
this may not be the last fight the SNB puts up, it appears the markets have
little confidence the SNB can implement its threats. Indeed, the SNB seems to
have looked for a graceful exit to its policies by declaring the threat of
inflation over, for the time being. Of course, that announcement spurred a
speculative rally, giving the green light to buy Swiss francs. That in turn
caused the SNB to state that they may intervene yet again; we would rather
have the SNB focus on sound monetary policy than on a cat and mouse game with
speculators they are bound to lose.
As policy makers are throwing around billions, if not trillions of
dollars, in desperate attempts to enforce their objectives, rational capital
allocation suffers, planting seeds for new distortions and bubbles.
In the coming days, the stress test on the eurozone banks will be published;
don't miss our analysis by signing up to our newsletter; we will also give an
update on our views in our webinar on July 29, 2010 - please register.
We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency
Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual
funds that do not typically employ leverage. This analysis is a preview of our
annual letter to investors; to learn more about the Funds, please visit www.merkfunds.com.
Axel
Merk
Manager, Merk Hard Currency Fund
The Merk
Hard Currency Fund is a no-load mutual fund that invests in a basket of hard
currencies from countries with strong monetary policies assembled to protect
against the depreciation of the U.S. dollar relative to other currencies. The
Fund may serve as a valuable diversification component as it seeks to protect
against a decline in the dollar while potentially mitigating stock market,
credit and interest risks - with the ease of investing in a mutual fund.
The Fund may
be appropriate for you if you are pursuing a long-term goal with a hard
currency component to your portfolio; are willing to tolerate the risks
associated with investments in foreign currencies; or are looking for a way
to potentially mitigate downside risk in or profit from a secular bear
market. For more information on the Fund and to download a prospectus, please
visit www.merkfund.com.
Investors
should consider the investment objectives, risks and charges and expenses of
the Merk Hard Currency Fund carefully before investing. This and other
information is in the prospectus, a copy of which may be obtained by visiting
the Funds website at www.merkfund.com or calling 866-MERK FUND. Please read
the prospectus carefully before you invest.
The Fund
primarily invests in foreign currencies and as such, changes in currency
exchange rates will affect the value of what the Fund owns and the price of
the Funds shares. Investing in foreign instruments bears a greater risk than
investing in domestic instruments for reasons such as volatility of currency
exchange rates and, in some cases, limited geographic focus, political and
economic instability, and relatively illiquid markets. The Fund is subject to
interest rate risk which is the risk that debt securities in the Fund's
portfolio will decline in value because of increases in market interest
rates. As a non-diversified fund, the Fund will be subject to more investment
risk and potential for volatility than a diversified fund because its
portfolio may, at times, focus on a limited number of issuers. The Fund may
also invest in derivative securities which can be volatile and involve various
types and degrees of risk. For a more complete discussion of these and other
Fund risks please refer to the Fund's prospectus.
Foreside Fund Services, LLC, distributor.
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