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Last Updated on: 11th March 2015, 05:18 pm
Last week, investors were hit with a harsh lesson of why they shouldn’t trust central banks. The Swiss National Bank, usually an example of steady management, shocked the World economy with an overnight reversal of a long standing monetary policy. This move caught nearly everyone off guard and put anyone who was counting on the promises of central bankers in a very tough position.
The SNB surprise – Ending the franc to euro cap
Since 2011, the SNB based its monetary policy on a fixed cap between francs and Euros. The cap kept the currency exchange rate at 1.20 francs per Euro. However, over the past few months, the value of the Euro has plunged against the US dollar and this made the heads of the SNB uncomfortable. They believed that they were undervaluing the franc by keeping it pegged to the depreciating Euro.
As a result, last week they announced that they were ending the peg and would allow the franc to fluctuate against the Euro. This was a big surprise because the SNB had given absolutely no warning ahead of time of this decision. Just a few days before the announcement, the vice-chairman of the SNB said that the peg would continue to be a key part of the bank’s policies so this reversal seemed to come out of nowhere.
Fallout from this decision
The SNB’s announcement shocked the stock and currency markets. Right after the announcement, the Swiss franc immediately jumped up about 30% in value against the Euro before eventually settling at a price of around 1.04 francs per Euro. The Swiss Franc also saw a massive gain against the dollar with the dollar losing about 15% of its value against the franc. (source)
Traders and financial firms who were banking on a predictable value of the Swiss franc faced huge losses. Citigroup and Deutsche Bank reported losses of $150 million while Barclays lost about $50 million. The European foreign exchange broker Alpari went insolvent over this move while the Foreign Exchange Commodities Broker, an American broker, needed to get an emergency loan $300 million loan to stay solvent.
Hedge funds also faced large losses as some were locked into trades where they borrowed Swiss francs to buy dollar and euro-backed investments. The sudden increase in the value of the franc is going to put pressure on their balance sheets and the long-run damage is still uncertain.
Stock markets took a hit as well. Index funds of Swiss stocks lost about 10% while American markets closed the week down about 5%. All and all, the SNB announcement had pretty devastating consequences.
Swiss stocks took a beating immediately after the announcement (source)
The problem with trusting central banks
This is just one more example of why it’s so dangerous to use investments that rely on the decisions of central banks. When you invest in stocks, bonds, or currencies, you’re just a surprise rate increase or policy switch away from disaster and there’s really no way to predict when this will happen. Even the heads of the ECB stated that they were caught completely off guard by the SNB’s reversal so regular investors have no chance.
That’s what makes gold such a valuable investment in these uncertain times. Since the value of gold isn’t backed by any one currency, it’s immune to the wild decisions of central bankers. Not surprisingly, during this tough week gold gained about 5% in value.
This event is a wakeup call to the potential destructive powers of central banks. When you consider how much damage a small player like the SNB can cause, it’s scary to think of the consequences of a misstep from the Fed or the ECB. Investors should keep this in mind as a warning and make sure to protect their portfolio from central bank risk with a solid investment in gold.