Late last week, a friend from a hedge fund asked me what I thought about the rumor that Swiss National Bank was buying gold. Suddenly, twin images of May 1998 loomed in my memory. This was the time when two conflicting pieces of news hit the gold market. Pakistan’s and India’s nuclear tests and a Swiss research paper echoing an earlier recommendation of the Economic Committee of the National Council, advocating the sale of Swiss gold reserves.

The latter proved to be a watershed event for the struggling gold market. As recently as late 1980s, the alpine rock solid Swiss Franc was backed by foreign exchange reserves 40% of which were held in gold. For a country whose exports represent over 50% of its GDP, this was always a remarkable vote of confidence in the metal. After all, your current account surplus does not automatically vest you with gold receipts. Switzerland’s gold endowment was considered a testimony to the lasting defensive properties of such a significant gold stock.

What followed the May 1998 announcement was a triple waterfall. Gold market reacted very negatively to the announcement. Yet, amid political debate in the country, the then President of the Swiss National Bank confirmed the intention of the proceeding with the gold sales. The market reacted again, sending gold south. Finally, SNB actually began the sales process in May 2000 and continued its regular sales at around 20t per month. The market froze. In South Africa, AngloGold’s CEO and the National Union of Mineworkers marched together to hand protest notes to the Swiss diplomatic mission. Initially, it all looked like a sad example of a mismanaged sales process, one that was mimicked broadly by other European central banks. Until the Central Banking Gold Agreement (CBGA) was signed in the 1999 and a new era dawned on the beleaguered gold market. Switzerland was among the signatories to the Agreement.

Fast forward ten years and the rumors surrounding Swiss National Bank are again emerging. As in the 1990s, the rumors tend to reinforce the prevailing sentiment. “Only” the direction has changed.

In the intervening period, Swiss gold reserves bottomed out, in value terms, in 2003. In the last three years, the bank sold 160t of bullion and announced that no further sales were necessary. Yet something quite extraordinary has now happened to Switzerland’s official reserves. The reserves, which for many years hovered around the $70bn mark and then doubled since the onset of the global financial crisis in 2007, suddenly jumped a further 50% between April and May this year. Unexpectedly, Switzerland has overnight become 7th largest foreign reserve holder after the Asian and oil producing economies. This occurred due to the proactive stance of the bank’s new leadership to dampen speculative inflows into CHF. Indeed, Swiss National Bank bought more European government bonds since Brussels’ shock’n’awe strategy announcement than the European Central Bank itself. Much of this hyperactivity was apparently caused not so much to protect Swiss exports, but rather to shield Eastern European economies whose debt is largely denominated in Swiss Francs. It has been reported that as much as 60% of Hungarian mortgages are CHF-denominated. But in the process, the gold component of SNB’s expanded reserve, if left unadjusted, has now shrunken from 24% to 15% of the total.

Appearing as a key supporter of the Euro, the Swiss National Bank has made an announcement that it would now cease the CHF-weakening activity. It is unclear if this pledge will last. Since this announcement, the Swiss Franc has already hit an all time high against Euro.

What does it mean for SNB’s future gold strategy? The Swiss National Bank differs from many other central banks by having a mandate to actively manage its assets and since the outset of its gold sales program it hired personnel to trade bullion. Importantly, the Constitution of Swiss Confederation obliges SNB to hold part of its reserves in gold. Until the late 1990s, this “part” was defined as 40%. Since then, a 25% ceiling has been introduced. If the ratio has to be observed in future, the question of my hedge fund friend is well timed.

The gold market has experienced some unexpected jumps this month. On two occasions over the last two weeks, the market saw unusually large orders coming through. The typical rumor mill points fingers at central banks, whose buying decisions are only belatedly clarified. The most recent example thereof is this month’s disclosure of Saudi Arabia’s “accounting issue”, whereby the country’s gold reserves were boosted by a whopping 180t.

The first year of the 3rd CBGA runs out in September. So far, only 10% of the 400t quota has been filled. Would this mean that European central banks will now scramble to liquidate the remaining 360t over the softer summer months? I strongly doubt this. But should they do so, it is not impossible that some of the bullion will head back to the familiar safety of the Swiss vaults.

What a difference 10 years make.

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Tags: foreign exchange reserves, gold in central banks, Hungary, Saudi Arabia, Swiss Franc, Swiss gold, Swiss National Bank's gold