Swiss Turmoil Hints at Future Lehman Moments

The scale of the damage in the aftermath of Switzerland's currency shift is a reminder that contagion is always unpredictable and markets always overshoot.

A Swiss Warning.

Photographer: Valentin Flauraud/Bloomberg

For three years, the Swiss National Bank successfully sat on its currency, selling the franc whenever it threatened to appreciate too much for the comfort of Swiss exporters. Yesterday, it tore up that policy, inciting the equivalent of a riot in the currency market and trashing retail brokerages from New York to New Zealand. While victims of the turmoil ponder whether Swiss policy makers are irresponsible or just incompetent, the scale of the damage is a timely reminder that contagion is always unpredictable, that markets always overshoot, and that traders, when they smell profit, can outgun central banks.

Currency analysts all seem to assume that the Swiss central bank, after abandoning its 1.20 euro cap, expected its currency to settle at about 1.10 or even 1.15 per euro. Instead, the franc is trading at parity with the euro -- a stunning blow for exporters. If the central bank thought that simultaneously cutting its deposit rate to -0.75 percent would deter franc purchasers -- SNB President Thomas Jordan called negative rates "a very strong instrument" -- it was badly mistaken.

Jordan also said markets "tend to strongly overreact" to surprises, and that the situation would "correct itself over time." Maybe. But as of today, abandoning the cap rather than, say, adjusting the level seems to have been a wild miscalculation. And it contains a lesson for both U.S. and European policy makers.

By the third quarter of this year, the Federal Reserve's 0.25 percent interest rate is expected to at least double, according to economists surveyed by Bloomberg News. The Fed already has an idea of what the market impact will be: The so-called taper tantrum in May 2013, when then Fed Chairman Ben Bernanke first suggested the U.S. bond-purchase program would be scaled back, saw the yield on the 10-year Treasury jump half a percentage point in four weeks to end the month at 2.13 percent.

There's a risk, though, that this time, having flagged the prospect of a change so far in advance, policy makers will be complacent about the probable market reaction. That's what happened in 2008 when Lehman Brothers went bust. Treasury officials convinced themselves that the financial crisis had been rumbling on long enough for participants to have shielded themselves against the collapse of a big firm; instead, their earlier decision to contribute $29 billion to JPMorgan's rescue of Bear Stearns had created a false sense of security about how far the government would go to support the financial system.

In the euro region, there's a similar, though diminishing, risk surrounding the potential for Greece to exit the common currency. Today, two Greek banks applied for emergency funding from the national central bank. This could be a signal that depositors are pulling their money out at an alarming rate. (They already withdrew 3 billion euros in December, leaving about 161 billion euros in the domestic banking system.) Or, it could simply be more scaremongering ahead of the Jan. 25 election -- an effort to frighten Greeks into believing that a vote for the anti-austerity Syriza party is a vote for economic chaos and financial ruin.

Because Greece has been an economic basket case for so long, investors won't be surprised if a fight between a new government and the country's creditors leads to the nation either abandoning or being kicked out of the euro. Maybe other weak countries in the common currency wouldn't be scathed by a so-called Grexit. Again, maybe. But the danger of contagion blowing like wildfire through the euro zone is too great for the gamble.

So when the Fed contemplates the likely effects of raising rates, or German politicians decide whether to play hardball with new anti-austerity Greek leaders, they should study a chart showing what happened to the Swiss franc after Thursday's decision: 


Maybe it would help them avoid doing anything they might swiftly regret.

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