A new research report from JP Morgan Chase Institute highlights the impact of central bank communication choices on financial market volatility.
In the report, Does the Timing of Central Bank Announcements Matter?, the authors analysed data around the Swiss National Bank’s (SNB) decision to remove the EUR/CHF floor in January 2015, and found evidence that the timing of the decision increased subsequent market volatility.
This latest research builds on a previous paper released by JP Morgan in June 2018, in which it found evidence that many hedge funds had predicated trading strategies on the belief that the SNB would maintain the EUR/CHF floor at 1.20. Essentially, these hedge funds executed a long EUR/CHF strategy in which they would buy EUR and sell CHF if and when the exchange rate got near the 1.20 floor in the anticipation that EUR would appreciate relative to CHF as the SNB acted to defend the floor.
“As long as the SNB was committed to maintaining the EUR/CHF floor by purchasing an unlimited amount of EUR against CHF at 1.20, the potential loss on such a position was limited to the difference between the entry exchange rate and the 1.20 floor. However, if the SNB removed the EUR/CHF floor, CHF was likely to appreciate, and the long EUR/ CHF strategy would suffer severe losses in such a scenario. The upside of the long EUR/CHF strategy could be unlimited, depending on how EUR/CHF evolved. Thus, as long as the SNB’s Minimum Exchange Rate policy remained in place, the risk/reward ratio of the long EUR/CHF strategy was compelling,” the latest report explains as a reminder.
The report also notes that the net flows during the 24 minutes following the surprise announcement from the SNB indicated that net risk transferred was largely one way – all investor sectors were either buying CHF or absent.
The data presented in the report shows that in the first three minutes after the announcement, hedge funds bought large quantities of CHF (or, put another way, sold EUR/CHF), trading in a manner consistent with the appreciation of CHF. Because hedge funds and other institutional investors were on net buying CHF as it appreciated, according to JP Morgan, market makers were left as the only market participants selling CHF during this critical stage.
From the JP Morgan report: “While we don’t measure the connection directly, the hedge fund buying just after the press release may have amplified the initial move in the exchange rate – between the 9:30 am announcement and 9:54 am, EUR/CHF dropped from 1.201 to 0.895, before recovering to settle around 1.053 at the end of the London trading day.
“We hypothesize that the long EUR/CHF strategy described above could partially explain why hedge funds were buying large quantities of CHF in the three minutes after the policy was removed. The immediate and sharp appreciation of CHF just after 9:30am created losses for any investor left holding the long EUR/CHF strategy. Hedge funds losses were likely amplified due to the use of leverage. Hedge funds continued to purchase CHF over the rest of the day, and by the close of business in London, their CHF purchases outpaced sales by nearly six to one,” the report states.
It’s at this point that the report starts to draw new conclusions from the data available, the first of which is that after hedge funds executed this long EUR/CHF strategy, they then sold EUR/CHF in the days immediately preceding the next regularly scheduled SNB announcement. The reason why they did this, according to the report, was to reduce their potential losses were the central bank to remove its Minimum Exchange Rate policy at the next meeting.
The second finding in the report is that hedge fund confidence in the SNB’s willingness to maintain the EUR/CHF floor appears to have actually peaked in the four weeks before the central bank dropped it.
The hedge fund net flows in EUR/CHF show that these funds bought more EUR/CHF between December 18, 2014 and January 14, 2015. The report illustrates the impact of the accumulation of these trades by showing cumulative net flows in EUR/CHF between June 2014 and January 14, 2015. The fact that the cumulative scaled net flows were increasing ahead of the surprise announcement suggests that hedge funds had a high level of conviction that the EUR/CHF floor would remain in place.
Data from the Commodity Futures Trading Commission (CFTC) shows that hedge funds also accumulated short positions in CHF FX futures in the month prior to the SNB announcement. Indeed, as of January 13, 2015, hedge funds were net short over 23,000 CHF FX futures contracts, their largest net short position during the Minimum Exchange Rate policy period.
One notable point made in the report is that after the December 18, 2014 announcement from the SNB to cut CHF three-month LIBOR into negative territory, hedge funds bought more EUR/CHF and sold more CHF FX futures, as clearly indicated by these graphs. This is significant because the reduction in CHF three-month LIBOR increased the incentives for investors to enter the long EUR/CHF strategy, as it made long EUR/CHF positions a more positive carry. It’s also worth remembering that as part of the December 18 announcement, the SNB reaffirmed its commitment to the Minimum Exchange Rate policy.
Further, the report makes two additional observations regarding the hedge fund response to this announcement.
“First, the increase in hedge fund trading volume on December 18, 2014 itself relative to the three days prior suggests that the surprise policy announcement made on this date was not anticipated. Second, the accumulation of risk associated with the long EUR/CHF strategy would be consistent with hedge funds viewing the introduction of negative interest rates by the SNB on December 18, 2014 as a complement to, rather than an eventual substitute for, the EUR/CHF floor,” it states.
The report says that the increased risk allocated by hedge funds to the long EUR/CHF strategy in early 2015 probably added to the buying of CHF and the sharp appreciation of CHF in the minutes following the floor removal. This is because, in order to unwind the EUR/CHF strategy, hedge funds bought a large amount of CHF just after the SNB removed the EUR/CHF floor, and between the 9:30am announcement and 9:54am, EUR/CHF dropped from 1.201 to 0.895.
“Research has shown that liquidity in CHF dropped just after the SNB announcement. Consistent with the model of exchange rate dynamics we described in previous research whereby exchange rate changes are a function of net flows, news and liquidity, large net flows that occur just after news breaks and during a period of low liquidity are likely to increase market volatility,” adds the report.
Timing is everything
The essential takeaway from all this is that, if the SNB had removed the EUR/CHF floor at a regularly scheduled quarterly policy announcement, hedge fund long positions in EUR/CHF may have been smaller, leading to less buying of CHF and therefore less volatility in EUR/CHF just after the announcement.
So the answer to the question posed in the title of the report is, yes, apparently the timing of central bank announcements does matter. If institutional investors generally exhibit similar behaviour and also prepare for a range of possible outcomes in the days before scheduled central bank announcements – as the data suggests that they typically did before SNB announcements – then making unexpected monetary policy changes at a previously scheduled meeting may produce more balanced post-event flows. By contrast, enacting unexpected policy changes via a surprise announcement may not allow investors to adjust their risk in advance, which in turn leads to directional net flows that can amplify price movements.
Thus, the report concludes: “In the instances when market stability is important, announcing policy outcomes at odds with market expectations at a regularly scheduled meeting may lead to less market volatility. When policymakers want markets to reprice rapidly and are less concerned with market volatility, releasing unexpected policy outcomes as a surprise announcement may be more effective.”
Commenting on this conclusion, Diana Farrell, president and CEO of the JPMorgan Chase Institute, says: “Greater understanding of the ways in which institutional investors prepare for planned announcements and react to surprise announcements is a critically important tool for central banks as they consider changes in monetary policy.”
Farrell adds: “Our analysis of hedge fund behaviour in the SNB Minimum Exchange Rate policy period provides a case study for how central banks can choose between planned or unanticipated announcement timing to achieve their policy goals in a manner that minimises unintended market volatility or by surprising investors with market-moving news.”