Marble Floor.

Stock markets continued their sell off right into the end of last week, as panic spread with regard to the Greeks and their ongoing membership of the Euro. The potential for further falls certainly exists, especially while the ECB and European Governments persist in communicating with all the clarity and unity of a bunch of sugar-filled kindergartens. Certainly there is no refuge seen for stocks from the window of the credit markets where, as the following chart clearly shows, a veritable collapse in high-quality corporate debt yields has been seen:

We're not spending time on the stock markets in today's post though, the madness of the last year's stock rally is a subject we've even bored ourselves of! Rather we have a perspective on the Great Swiss Euro Peg to offer. Firstly we acknowledge that this isn't, of course, a "peg" but rather a "floor" versus the Euro to which the Swiss central bank have committed themselves to defending at any cost. Analysing the thinking behind "the floor" is an interesting exercise; for reasons of illustration let us imagine that the members of the Eurozone are gathered inside a boat, the hull of this boat has impacted an Iceberg of debt and been breached; the Swiss, in their luxury yacht, have come upon the hapless Eurtanic now listing in the open sea. At this point the Swiss could, perhaps, have assisted a few of the members of the sinking Eurtanic to safety -women & children as it were- then set sail for the calmer vista of Lake Geneva... instead the Swiss appear to have holed their envied yacht and leapt, with  surprising gusto, aboard the sinking vessel. Is this a mission in solidarity or suicide? Who knows. One must suspect that, to take such drastic action, the Swiss have extremely solid information that the Euro will not sink beneath the waves. Or, perhaps, as we previously theorised, the two giant Swiss banks would have been so completely battered by a Euro collapse that the Swiss were effectively tied to the Euro already.

Whatever the thinking behind it, the move has shaken the currency markets and, as we see it, presented some superb trading opportunities. Reaction to the imposition of the floor has been revealing; many firms appear to have been caught on the wrong side of the trade - long the Swiss Franc (CHF) and short the Euro - and experienced instant 10% percent losses the morning the floor was announced. Many of these traders appear convinced that the Swiss Central Bank will eventually lose the battle to defend the 1.20 level.  An article over the weekend in the Wall Street Journal confirmed this thinking:

Hedge funds are considering ways to mount a counterattack against the Swiss National Bank, whose attempt to wrest control of the surging franc caught investors off-guard.

But we think they're wrong. Badly wrong. Allusions have been drawn, repeatedly, to the Bank Of England failing to defend predetermined trading levels for the Pound in the early nineties; famously the BoE were broken by speculators who sold vast amounts of Sterling until the Bank gave up defending it. However, in that case the Bank of England were attempting to hold up the value of the Pound or, to think of it in another way, hold down the relative value of the Deutsch Mark. This was proven to be an exercise in folly. But the Swiss situation is not just different it is entirely opposite. The Swiss are merely promising to devalue their currency as and when required and, considering they can print as much of it as they fancy, how can speculators sustain the fight? To draw another stretched metaphor (not quite as dramatic as the sinking ship): if the Swiss Franc were a stock like, say, Microsoft - this is equivalent to Microsoft saying we will issue new shares as required to keep the price below $20 a share. Trying to buy enough shares to "beat" them is just not a smart way to spend one's money. Similarly, we expect that traders who believe the Swiss Franc should be bought in preparation for the breaking of the Euro floor will be proven wrong. Not only will they be proven wrong but they are, in fact running a much larger risk than might initially be thought. How so? Well this, as we see it, is critical to the Swiss strategy and it is not an idea we have yet seen mooted elsewhere: the Swiss will simply move the floor higher. Yes the 1.20 level versus the Euro has now been named, but what is to stop the Swiss announcing next month that 1.25 is the new level, or 1.30? They can, and might, do exactly that, instantly wiping fortunes off the books of anybody who bought Francs in an attempt to crack the 1.20 floor and, in the process, cementing belief in their resolve. If we're correct in this stance, and we're confident that we are, then the trades to profit are really rather simple:

• As long as the Euro remains under pressure, sell the Swiss Franc against anything, particularly the last remaining safe-haven: the US Dollar.
• If the 1.20 level is approached, sell the Swiss Franc heavily against the Euro.

The chart above shows the moves in various currencies versus the Swiss Franc following the announcement of the Floor. All have clearly strengthened in value, with the only straggler being the Euro, we fully expect this trend to continue.

The laws of thermodynamics demand that the Swiss action must have a consequence, and so it does: inflation. The printing of Francs to defend their floor ultimately devalues each Franc, so the prices of "things" will rise to fill the void. Currently the Swiss are experiencing inflation of below zero (falling prices), so any fears of crippling inflationary pressures are some distance off. However, to complement the two trades above, we would also consider the selling of Swiss ten-year debt; currently such debt yields a meagre 1% and we expect that, as "the floor" gains respect in the financial arena, the realisation that Swiss interest rates must climb will also dawn, pushing yields closer to recent norms which are, as the chart below illustrates, around the 2% mark. Downside on such a trade is also limited as a sustained fall below 0.75% for ten year debt is an extremely unlikely scenario.

Finally, on the day that is in it, a nod westward: to the towers that defined a time, a city and a nation.
In our memories they stand proud; glittering in the night.