09/09/2011: SNB decides enough is enough

Perhaps, it was one of the boldest moves by any central bank or economic decision-maker since the beginning of the financial crisis in 2007/08. Certainly, it was one the most unexpected, and it must have caught many investors on the wrong foot.

At 10 a.m. local time on 6 September, the Swiss National Bank pounded a fist on the table and said, “Enough!” The communiqué was unambiguous and left no room for interpretation or second-guessing: “With immediate effect, (the SNB) will no longer tolerate a EURCHF exchange rate below the minimum rate of CHF 1.20. The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities.”

The markets received the message loud and clear. Within seconds, the Swiss franc lost 10 big centimes against the euro and seven against the US dollar. To all those who had argued that the central bank of a tiny country like Switzerland cannot withstand the power of the markets, the SNB’s bold move was a strong counterattack. Indeed, a central bank can always fight the appreciation of its own currency. It has the means: “unlimited” quantities of money created through the printing press. All it needs is the will to do it and the ability to bear the long-term consequences.

The first critique that came after the move was an obvious one: What would happen with inflation? At the moment, this debate is futile. With the largest Swiss retailers Migros and Coop slashing their prices, and with export firms extending workers’ hours to the limit without increasing their salaries – thus effectively decreasing hourly wages – Switzerland is on a deflationary path. No doubt about it, inflation pressures will come in the long run; but even at a rate of 1.20 against the euro, the Swiss franc is currently having a deflationary effect. It means the long run can be rather long.

Markets will test the will of the SNB over the next couple of weeks. However, in my view, given the very strong language of the communiqué – and unless the SNB wants to completely lose its credibility – it will defend the 1.20 limit tooth and nail.

What does this mean for investors? As long as the SNB is defending the 1.20 limit, the Swiss franc in principle no longer bears any appreciation risk against the euro. This fact could be the basis for building up carry trades by using the franc as a funding currency to invest in bonds in euros, with higher yields than the ones in Switzerland.

Should this strategy catch on and become fashionable, the SNB will have won the battle, because carry trades usually undermine the value of a currency. As a funding currency, the Swiss franc could quickly retreat against the euro to 1.25, 1.30 and even beyond without the need for further SNB intervention.

Of course, it is still too early to say that the SNB has won the war against the brutal appreciation of the Swiss franc. But it has at least won a battle by spreading doubt among the markets that the franc is as good as gold and a safe haven. In my view, with a strong will and thanks to the oddity of carry trades, it might be able to extend its advantage sooner rather than later without putting too much money on the table.