Inside investment: Swiss franc and euro – the allegory of the man cave

By:
Lincoln Rathnam
Published on:

How did the relationship of the Swiss franc and the euro turn out to be purely platonic? Conscious uncoupling was perhaps inevitable.

cave 600


The Swiss are notoriously conservative. It is said that they get up early but wake up late. Nonetheless, wake up they do, eventually. On Thursday, January 15, they came to with a start and the unexpected blast from the Swiss National Bank alarm clock left shaken traders around the world staring with terror at their TAG Heuers and wondering if it was the end time.

The Swiss franc, which since late 2011 had been trading at around SFr1.2/€1, and which had previously been in the SFr1.4-1.5/€1 range for several years, would no longer be capped by SNB euro-buying. The franc immediately shot up to SFr0.85/€1 just long enough to bankrupt a gaggle of currency traders, and then settled in subsequent days at around SFr1/€1. Even among the survivors, there were haircuts. The $50 trim in Zurich barbershops in a flash cost $60, and the traders were short at the $50 price.

The sudden breakup of the euro-franc couple came as a shock. The perception was that they were an 'item’, bound together economically and geographically. They looked good together and seemed unusually compatible. In retrospect, of course, their friends could see precursors of problems. Some of the euro’s actions might be interpreted as trying to ease its way quantitatively out of the relationship (all those late night meetings at the ECB in Frankfurt). The franc, for her part, had been building up reserves, and on January 9, just days before the breakup, had reported an astonishing profit of SFr38 billion for 2014. (Foreign currency gains – why the need for all this extra money?)

Perception had diverged from reality, leading us to ask: "What is reality?"

In 1973 Burton Malkiel wrote 'A random walk down Wall Street’ in which he argued that price movements are independent of each other; they are random. This means that the present price must also be a random value. Malkiel’s book grew out of efficient market theory, which posits that prices incorporate all known information. This in turn means that only unknown information can change the price. What is this unknown information? We do not know. So we cannot say what the next price will be.

In this context, what do we make of oil at $81/barrel compared to $45/barrel? What does SFr1.20/€1 mean, as opposed to SFr1/€1? What information is contained in the DJIA index price of 17,500? 12,500?

It’s all Greek to me

Any discussion of the nature of reality and the relationship of perception to reality brings us back to an ancient cave. In Plato’s famous allegory of the cave, prisoners are chained and immobilized facing a cave wall. Behind and above them the cave is open to the light. In that light, the world goes by, but all the prisoners can see are the shadows of these events. We are, of course, the prisoners, and we are trying to discern reality from the shape and movement of shadows, just like a forex trader watching the numbers, words and graphs on his computer screen. Plato reminds us that symbols are not reality and that we need to use reason to understand them. Using reason, we develop a theory of reality based on shadows.

Religions offer us a more direct route to reality, divine revelation, provided by prophets, mystics, and God Himself. There are non-divine revelations as well. For example, while writing this essay, I made a pot of tea using two Salada tea bags. Written on the tag of each bag were a few thoughtful words. One said: "Time spent in getting even would be better spent in getting ahead." (Good advice for forex traders.) The other said: "Light travels faster than sound: that is why some people appear bright until they speak." (Worth pondering by magazine writers.)

Further reading
swiss_francs_large
Swiss franc: special focus

Unfortunately, we cannot rely on revelation in our day-to-day investment activities. So let us update Plato’s metaphor with a modern, more relevant one. Imagine yourself in a cave under an alp in Switzerland. This would not be the 27-kilometre-long cave at Cern, in which resides the Large Hadron Collider; it is another cave. Inside, some forex traders are chained facing the wall; on the wall is a Sony 85" Ultra-High-Definition TV set tuned to CNBC. The traders also have access to a well-stocked fridge, a wet bar and a package of sports channels. Given the high level of testosterone one finds on trading desks, regardless of gender, let us call this 'the allegory of the man cave’.

Cross rates are flashing across the screen: 1.1667, 1.0038, 1.4366, .0853, etc. The voice of an expert explains the significance of each: "This happened", "That most likely will occur", etc. From only this, the traders develop a theory that 'this’ will lead to 'that’, while outside the cave in the land of reality a 'different this’ is leading to 'another that’. What is the 'different this’ and the 'another that’? This is not yet imagined inside the cave.

As rational beings, we seek to find meaning in prices. This can be good if we are constrained by a theory of reality and that theory informs us that much is beyond our ken. We would do well to limit our bets based on guesses and theories, some of which will be right and others wrong, in a random sort of way. Proceeding conservatively, traders and investors will never be as great as the London Whale, but if we keep in mind that cross rates are purely platonic, we have a chance of becoming a long-lived Manchester tuna, or some other big fish.