THE SWISS ENTER ALICE IN WONDERLAND / THE FINANCIAL TIMES ( VERY HIGHLY RECOMMENDED READING )

August 14, 2011 8:01 pm

The Swiss enter Alice in Wonderland territory

By Gillian Tett

Last week, something astonishing happened in Switzerland. In the London interbank offered rate market – where traders bet on future rates – implied Swiss interest rates plunged into negative territory.


Yes, you read that right: if you want to lend Swiss francs or make a deposit in the next year, you must pay for that privilege, or so the Libor market implies. The normal assumptions of finance have been turned upside down; call it Alice in Wonderland economics.


Nor is this the first time. In the 1970s the Swiss National Bank imposed negative interest rates on foreign accounts to deter inflows; and in 2008 some short-term Swiss market rates briefly turned negative. That also happened in Japan in the late 1990s. Recently, amid financial panic, some dollar short-term rates have touched negative territory.


What makes the Swiss situation so remarkable, however, is that it affects not just ultra-short rates. On Friday, futures markets predicted negative rates until 2013 (and minus 8 basis points next summer). This is unprecedented. Thus investors should watch closely to see what happens next, After all, it is a sign of how distorted the global financial system has become amid eurozone and US turmoil – and the pressure this is creating in currency markets.


Last week’s swing, for example, was sparked by the rise of the Swiss franc. In the decade before 2008, the franc traded in a relatively narrow band. However, since then, it has strengthened 40 per cent on a trade-weighted basis, as panicked investors seeking havens away from dollars or euros have purchased the currency.


Last year, the SNB tried to slow this trend with large-scale unilateral intervention. But after a brief hiatus, the franc rose further, creating SFr10bn ($14bn) of losses for the central bank this year alone, and prompting some politicians to demand the resignation of Philipp Hildebrand, its governor. This summer’s chaos in the eurozone and dollar markets has strengthened the franc again. Indeed, last week Goldman Sachs described it as “the most overvalued currency” in modern history, 71 per cent stronger than fundamentals justified.


Unsurprisingly, the SNB warns that overvaluation threatens to create a recession and deflation. It is also causing losses for millions of east European homeowners with mortgages in francs, and (less visibly) for European banks holding franc-linked derivatives contracts.

Thus the SNB faces pressure to act. But last year’s experience has left it wary of intervention. So on August 3 it launched a desperate experiment: in 10 short days, it raised liquidity from SFr30bn to SFr120bn (an injection into the financial system worth a stunning 20 per cent of gross domestic product), and conducted currency swaps. The hope is that this shock therapy will push markets rates into such negative territory that foreigners will not want to hold francs.


Will it work? Opinions are divided. The good(ish) news is that the franc did weaken late last week. The bad news is that money markets also started to gum up, partly because no one knows what negative rates will do to the financial system. They might, for example, force banks to impose negative rates on Swiss savers. “Even sophisticated investors [are] inquiring about the possibility of bank runs should people decide that holding cash in bank accounts [is pointless],” says Beat Steigenthaler of Swiss bank UBS. This “nonsensical” idea reflects the “rather chaotic turn the money markets have taken”, he says.


Meanwhile, some doubt that even this shock treatment will stop people buying francs; they want the SNB to reimpose the 1970s controls. “The Swiss authorities do not seem to have woken up to the fact that the only way to control this [currency swing] is to introduce negative interest rates for large foreign deposits,” says Christopher Wood, analyst at CLSA in Hong Kong.


Do not bet on this happening soon, however. SNB officials insist (probably correctly) that imposing capital controls would undermine Switzerland’s status as a financial centre. They also doubt the 1970s measures even worked. And there is a third important point: though data are patchy, it seems (unlike the 1970s) that flows in global derivatives markets, not bank accounts, are driving the franc higher. Thus, imposing negative rates on bank accounts by fiat may not work as well as lowering market Libor rates through indirect means.


Nevertheless, if global financial turmoil continues, pressure on the SNB will rise. If so, its next step will probably be further currency intervention, despite last year’s unhappy experience (not to mention the risk of sparking a currency war). The SNB’s only comfort is that domestic politicians are no longer calling for Mr Hildebrand’s head; it is now clear to all that Switzerland – like much of the west – is sailing into uncharted policy waters. The wild experiments could soon grow wilder still. Unless, of course, eurozone and US governments can solve their own problems. And cuckoo clocks might fly.
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Copyright The Financial Times Limited 2011.