The Scariest Thing About the Swiss Currency Decision

By Markets Fool.com

I was recently reading an article online titled "122 Things Everyone Should Know About Investing" by Motley Fool contributor Morgan Housel (Google it -- you'll enjoy what you learn), and while over 100 of these things that everyone should know are worthy of expansion into a full-fledged article, I'm going to focus on just one of them here, as events within the past month have made it all the more relevant.

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At No. 38 on the countdown is this: "As Nate Silver writes, 'When a possibility is unfamiliar to us, we do not even think about it.' The biggest risk is always something that no one is talking about, thinking about, or preparing for. That's what makes it risky."

Going into the middle of January, all eyes were on the price of oil as the critical risk in the market. Never mind that nearly 'round-the-clock coverage had been devoted for at least two months to the weekly, daily, and even hourly movements in the price of oil by that point. The many possible and often competing implications of these moves for both oil-producing companies and potentially every other type of stock had been analyzed to death -- and then killed a few times more for good measure. So anyone who had exposure to oil-price movements was into the third month of opportunities to prepare for every eventuality -- whether by buying more, selling short, hedging, or getting out altogether.

(And here I interrupt myself. I just made the mistake of looking up, and within my view was a television screen tuned to a business news network, which, of course, showed a blood-red screen with the words "Oil Shock" flashing. But I digress.)

The oil price dip, which is admittedly a significant macroeconomic development (and one we touched on in this space last month), has for the moment overshadowed the interest rate and Federal Reserve watch, which normally dominate the list of supposed investor risks that call for nonstop attention and measurement. But against this backdrop, and reminding us that bigger risks lie in what no one is talking about, came the dramatic news out of sleepy little Switzerland on Jan. 15.

It's not every day you see a major currency move 30% against other major currencies, but that's just what happened when the Swiss National Bank surprised everyone and dropped the currency's cap of 1.20 Swiss francs to the euro.

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This was a shocking move, and it should be a sign to any thinking person that the global economy is still on crisis-level footing -- because when you think about it, while the world was clearly shocked by the announcement, the SNB surely wasn't. It knew what was coming, and the bank removed the cap anyway, fully aware of the consequences that any unexpected currency shock brings to the global markets.

It behooves Switzerland, as a smaller economy surrounded by the eurozone, to have a currency that moves roughly in coordination with the euro, which is what it had done since the cap was instituted in 2011. This made trade and debt issues between the two markets fairly predictable, which benefits the smaller market.

However, the SNB, watching the weakening euro with alarm, chose to make an extremely costly decision now, rather than deal with even more costly conditions later, should the European Central Bank announce another round of quantitative easing late in January. Almost all of the SNB's assets are foreign currency reserves, and while the Federal Reserve's balance sheet is currently 25% of U.S. gross domestic product, the SNB's balance sheet is about 80% of Switzerland's GDP.

What's weird is that the value of the Swiss franc increased by a huge percentage basis against the dollar and (especially) the euro, yet many people are saying this move caused enormous damage to investors' perception of Switzerland as a safe haven. How can that be? If you owned Swiss francs, they just became a lot more valuable!

If I may tie this into a broader discussion, remember that instruments in portfolios have a job to do. A safe haven's job is to be safe, and predictable. The SNB's surprise announcement -- it didn't even bother to whisper to the International Monetary Fund -- completely upsets the notion that Swiss monetary policy is predictable. The Swiss franc's job isn't to earn people a fast 30%. (Though if that happens, well done!) Its job is to have largely the same purchasing power tomorrow as it has today, which is precisely why some of the world's largest currency-trading brokerages suddenly find themselves without sufficient capital. This event, in short, was a risk they had never even considered, much less prepared for. And large-scale leveraged exposure to an unexpected but real risk can be terminally costly.

Essentially, Swiss exporters -- including Nestle and Swatch -- suddenly find their goods far more expensive to produce relative to those of their competitors, whose operations are not paid for in Swiss francs. This is much more the case for Swatch than for Nestle, which manufactures its goods mostly outside Switzerland. But it's not good news for Swiss companies to find their currency suddenly near par to the euro, and the Swiss stock market took a massive hit on the back of the news.

Given the situation that the Swiss were in -- tethered unhappily to a union with the euro that no longer had long-term stability -- you might understand what the SNB did but remain confused about one thing: All of the media reports are focusing on the big losers when the Swiss franc surged against the euro. Isn't currency investing a zero-sum game? Should we be giving equal time to those who made a fortune?

Well, currency investing is kind of a zero-sum game. So yes, for all the investors who saw the value of their euros collapse against the Swiss franc, there should be some whose currency values surges. Those people are, on the balance, called "the Swiss." And unless they're going on holiday outside the country to gleefully spend their money across the border, they may not feel that a Swiss franc that's now some 20% higher against most major currencies is entirely a great thing. Most of their companies' expenses are in Swiss francs, while their foreign competitors' are in currencies that, functionally, are now much cheaper. (Keep that dynamic in mind as U.S. companies report their results this quarter and give guidance for the next. A lot of U.S. multinationals will point out that the strong dollar is leading to increased competition from cheaper foreign competitors and that profits earned abroad aren't as valuable in dollar terms as they were this time last year.)

The reputation of the Swiss franc as a safe haven has also taken a hit, which seems bizarre in the aftermath of all those massive gains. But what has essentially happened here is that the SNB has reminded people that they're counting not on natural law but on the decision-making of a few central bankers.

Remember last year when Elon Musk suddenly announced that he was putting all of Tesla Motors' patents in the public domain in the hopes that other developers would use them? Musk would make a terrible central banker. The last thing you want from a central bank, after all, is decisions that seem to come out of left field -- like this one in Switzerland.

There are lots of reasons the Swiss made this decision, and there are also many reasons they reasonably might have felt they couldn't have tipped their hands. We'll eventually learn who was swimming naked when the tide suddenly changes -- who was really paying no attention to the risks their business was exposed to. We already know a few: Retail and institutional online foreign exchange trader FXCM came within a hair's breadth of being instantly insolvent and has lost nearly 90% of its market cap in the wake of the a bailout that won't seemingly save shareholders much. In addition, English Premier League team West Ham United will be looking for a new sponsor next year after its current one, Alpari UK, collapsed as currency volatility evaporated its capital.

These events cause me to think about something else, however. The Swiss National Bank was essentially reversing a policy it enacted during the financial crisis. At some point the U.S. economy will also have to face the test of having crisis-level interest rates reversed, along with a whole host of other policies such as asset and bond purchases -- policies that have almost no precedent in the modern banking era. What are the chances that policy reversals will roil components of the U.S. market that have been rendered sanguine following six years of growth? Zero?

Probably higher. At any rate, it's a set of risks worth keeping an eye on in the upcoming months.

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The article The Scariest Thing About the Swiss Currency Decision originally appeared on Fool.com.

Bill Barker has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Motley Fool Asset Management manages two portfolios that own shares of Nestle and Swatch. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.