The "Gnomes of Zürich" Created a Financial Nightmare

Michael E. Lewitt

On Halloween, the Bank of Japan unleashed a massive quantitative easing program that included the purchase of bonds, stocks and ETFs in a desperate attempt to revive the terminally ill Japanese economy. This coincided with the end of the Federal Reserve's third round of QE in October.

At that point, the world entered the terminal phase of central banking that unleashed heightened volatility in stocks, bonds and currencies.

This week, the Swiss National Bank effectively abandoned the euro by removing the peg between the Swiss franc and the common European currency. With this move, which shocked financial markets and inflicted huge losses on currency traders around the world, the terminal phases accelerated to a dangerous new level.

Make These Moves Before the Next Shock

Next Thursday, the European Central Bank (ECB) is expected to announce a massive QE program (sources are targeting €500 billion in bond purchases) in its own attempt to stop European deflation in its tracks.

The odds of such a program creating sustainable economic growth in the region while fiscal policymakers do nothing is roughly akin to the odds of Bill Gross returning to work at PIMCO.

And once markets come to lose faith in the ECB's ability to do its job, the world will be down to just one central bank to whom it can continue to genuflect - Janet Yellen's Federal Reserve.

We all know what comes after the terminal phase of an illness - and investors need to prepare now by sharply reducing their exposure to the most expensive parts of the stock and junk bond markets, buying gold and municipal bonds, and increasing their cash positions to be in a position to take advantage of future bargains.

They can also earn huge profits by going long the dollar and shorting the euro and the yen by buying the PowerShares DB US Dollar Index Bullish (NYSEArca:UUP) ETF or the ProShares Short Euro (NYSEArca:EUFX) ETF.

The Franc's "Deadly" Allure Trapped Many

The Swiss National Bank's move was not just another stumble by a central bank. Those happen all the time. The Swiss franc holds a special status in global finance despite Switzerland's small size.

For many, Switzerland still holds the veneer of financial stability despite the fact that its central bank balance sheet has grown to 80% of its GDP. Ultra-low interest rates lured a wide cast of characters including Russian oligarchs and average Eastern Europeans to borrow Swiss francs to buy or finance their real estate.

Speculators around the world engaged in shorting the franc, betting that it would stay artificially low. And then billions of dollars in short positions came crashing down when the Swiss National Bank removed the euro peg, and the franc surged against the euro and the U.S. dollar.

A number of forex trading firms went belly-up, literally overnight, with one of largest U.S. retail firms, FXCM Inc. (NYSE:FXCM), having to be bailed out to the tune of $300 million by Leucadia National Corp. (NYSE:LUK) (the parent of investing banking house Jefferies) on Friday. Other brokers, including Alpari (UK) Limited and Global Broker NZ Ltd. also vaporized after their customers were wiped out and their lenders refused to rescue them.

This is what happens in a crisis and is a small preview of what could happen if the global economy deteriorates further.

The Swiss Bank Made an Impossible Promise

Even worse than the financial losses, however, was the damage inflicted on the image of central bank competence. Only a month earlier, on December 18, the SNB had promised to maintain its peg to the euro.

Apparently, having had occasion over the holidays to study Emerson and come to the conclusion that "a foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines," the gnomes of Zürich realized they were fighting a losing battle and threw in the towel.

It was not this week's announcement that was the blunder so much as the December promise to keep fighting an unwinnable fight that set up markets for a shock. The move has delivered a serious blow to the confidence in central banks that is the thin tissue that has held markets together since the financial crisis. The news is still being absorbed by markets and further knock-on effects are sure to surface.

Coming after the oil shock and the collapse in global interest rates, the Swiss shock is another nail in the coffin of the global recovery thesis. And stocks reacted accordingly despite recovering on Friday. The Dow Jones Industrial Average shed 226 points or 1.3% on the week to close at 17,511.57 while the S&P 500 dropped 25 points or 1.3% to end the week at 2,019.42. The Nasdaq Composite Index lost 70 points or 1.5% to 4634.38.

These moves hide the volatility that rocked markets during the week, however, with stocks making huge intraday percentage moves as investors wrestle with increasing uncertainty.

Bond Yields Extend Their "Disappearing Act"

While stocks were weakening, bonds were again rallying with the yield on the benchmark 10-year Treasury collapsing by 15 basis points to 1.82% (after trading as low as 1.75%). Of course, this looks like a high yield bond compared to the rest of the world. Swiss yields are negative out to 10 years. German 10-year rates fell to a record low of 0.411% while France's followed to 0.635%. Spanish and Italian 10-year yields fell to 1.5% and 1.659%, respectively. One has to ask what Europe can possibly accomplish with rates already so low - and the answer is obviously very little.

QE may well drive these yields lower, no doubt setting up an eventual opportunity to short weak sovereign European bonds once markets tire of the fallacy that monetary policies that have failed to generate economic growth over the past six years are miraculously going to become effective. Japanese yields continued their disappearing act as well, ending the week at 0.23%.

Countdown to Zero

When interest rates are at the zero bound - that is, when central banks have dropped their benchmark rates to zero - the adjustments necessary to properly reflect underlying economic conditions have to occur in currencies and other financial instruments.

When the U.S. dollar started rallying in 2014 against other major currencies, that was the signal that those adjustments were beginning to occur. That triggered the collapse in oil and other commodity prices. Now it is only a matter of time before global stock prices adjust. Right now the S&P is only down 3.4% from its closing high of 2,090.57 on December 29, 2014.

In contrast, bond yields are at or near record lows around the worlds and commodity prices have collapsed. Such an obvious disconnect between equity prices, which are supposed to reflect the earnings power and economic health of the economy, and bond and commodity prices, which are extremely sensitive readings of the same economic fundamentals, is unsustainable.

Experience demonstrates that bonds and commodities usually lead the stock market downward. Investors should prepare accordingly.

It All Comes Back to the Fed in the End

All eyes will no doubt turn back to the Fed. The yield on the two-year Treasury note has dropped sharply to 0.47% Friday from 0.75% last month. The Chicago Mercantile Exchange's Fed Watch site shows that Fed Funds futures aren't pricing in a rate increase to 0.5% until October.

Markets are again expecting the Fed to delay its already belated interest rate hike. Having already promised not to move for at least its next two meetings (January and March), markets will remain on pins-and-needles as they watch for any hint of the Fed's intentions.

At the zero bound, however, they are dancing in the tip of a pin because there is less and less that the Fed can do to stimulate economic growth. Placing too much faith in what central banks say rather than what they do can be dangerous to investors' health as those who were on the wrong side of the Swiss National Bank's about-face learned this week.

Michael E. Lewitt

About the Author

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Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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