Trying to Wrap Your Head around the SNB and Denmark?

When the Swiss National Bank lifted its cap on the franc, many thought they understood the message.  It had reached the end of its rope.  Some suggested the ownership structure of the SNB (owned by the Swiss cantons and individuals vs the stock exchange) opposed a further expansion of the its balance sheet (~80% of GDP vs ~20-25% in the UK and US by comparison. 

This was an important realization.  Out of the Great Depression, national governments discovered their balance sheets.  Although Reagan and Thatcher talked about rolling back the welfare state, neither succeeded.  The state actually grew under Reagan, and the number of federal government employee rose.  Still the Great Financial Crisis seemed to suggest limitations on the ever increasing state, and this was reflected in the loss of AAA rating by most high income sovereigns.  

In the Great Financial Crisis, central banks discovered their balance sheet.  Is there no limit?  From a purely theoretic point of view, there is not one as the central bank can swap reserves for securities endlessly.  The Bank of Japan is expanding its balance sheet by 1.4% a month. 

On practical grounds, there seems to be some limit.  By buying nearly the entire new supply of Japanese government bonds, the BOJ is disrupting the trading in the largest bond market in the world.  It has suggested that if it were to decide to increase its quantitative easing efforts, it would have to buy other instruments, such as regional bonds. 

However, as we argued since the SNB's surprise announcement, the decision to abandon the franc's cap does not mean that it has abandoned its strategy, and its balance sheet would likely still expand.  The cap was a tactic.  It changed tactics.  We compare the cap to a Maginot Line.  It abandoned this tactic.  It was too rigid.  Its intervention became predictable and therefore acted as a transfer of wealth to speculators.

Swiss officials have not suddenly embraced a true free-floating franc.  There are numerous signs of SNB intervention, which means  its balance sheet is still expanding.  Reports over the weekend claim the SNB has an unofficial target range for the euro of CHF1.05-CHF1.10.  What does the unofficial range mean?  Does not mean that it is not obligated to intervene to defend it?  Does it mean anything but a level that is desired by some officials?    

A couple of weeks ago, there was much hand-wringing about the SNB's loss of credibility.  Signs of SNB intervention helped weakened the franc last week.  It was the worst performing of the major currencies.  Its losses have been extended today, encouraged by the report of the unofficial target range.  Since last Monday's low near CHF0.9790, the euro has rallied nearly 9% to today's high just below CHF1.0590. 

If the SNB's balance sheet has not peaked, have interest rates bottomed?  The SNB is targeting 3-month LIBOR of -75 bp.  This is not the bottom of rates.  The -75 bp target is the middle of its 3-month LIBOR range of -25 bp to -125 bp.    The SNB has the flexibility of letting the LIBOR range to be explored.  It could cut rates into deeper negative territory.  Note that the one-month interbank rate is -172.5 basis points.  The government's 3-year note yields -77 bp. 

Denmark is in a somewhat different position.  The sole basis of its monetary policy is the link to the euro.  Under ERMII, it is obligated to keep the krone in a +/- 2.25% band around 7.46038 against the euro.  In practice, it has adopted a narrower band of 1%.  That is what is has been having difficulty maintaining.  It has intervened and cut interest rates three times last month.  Its key rate now stands at - 50 bp.   It can cut interest rates further and can continue to intervene.  

It has requested that the government stop issuing new debt to discourage speculators.  This will not stop the speculation, but it could have a larger impact on Danish rates.  The yield on the 10-year government bond was halved today to 18 bp.  It was 60 bp on January 21. 

There is another option for Denmark.  Unlike the SNB's franc cap, the Denmark's currency regime is supported by the ECB.  ERMII commits the strong and weak members to intervene to defend the band.  The lack of action by the ECB last week indicates that it does not feel compelled to defend the narrow 1% band.   When the SNB lifted its cap, an incredible mark-up (not appreciating trend) took place, more than 40% at one point.  Denmark has a fallback option.  Let the currency strengthen to the 2.25% band and force the ECB to show its hand. 

Part of the crisis in the euro zone is shaped by the abandonment of this principle that was enshrined in the ERM of reciprocal action by the strong and weak countries.  Both had a shared responsibility, agreed to by treaty, to participate in the adjustment process.  EMU freed Germany from such obligations while preventing its neighbors from devaluing, as they previously periodically did. 

The key take away is that policy makers and investors still do not know the practical limit of a central bank's balance sheet.  We have walked through Alice in Wonderland's looking glass.  A world of negative interest rates seemed incomprehensible a few short months ago.  Now estimates suggest that between Europe and Japan there are more than $3 trillion of debt securities with negative yields.  For so long, interest rates were thought to be bounded by zero.  Policy makers and investors are still fishing for the new limit.