Swiss National Bank is playing in extra time

• SNB renews its commitment to the 1.20 floor for EURCHF
• Franc appreciation must be prevented to avoid deflation
• Floor is at risk if ECB engages in QE

A couple of weeks ago Switzerland was squeezed out of the World Cup by Messi & Co after having held the line until deep into extra time. The Swiss National Bank (SNB) is displaying similar determination in its conduct of exchange rate policy. It set a floor of 1.20 for EURCHF in September 2011 and has doggedly defended it ever since but, almost three years later – well into “extra time” -— the question must be asked if/when the SNB will also have to exit the game, gracefully or otherwise.

The SNB has certainly shown it is up to the task it set itself back then and its exchange rate policy has probably been the most successful of any major central bank over the last few decades. Not even George Soros and his ilk have taken it on.......In its mid-June monetary policy update the bank said “The SNB will continue to enforce the minimum exchange rate with the utmost determination”, emphasising that 1.20 EURCHF is the minimum rate, and that even at 1.20 the Swiss franc is still overvalued relative to the euro. Furthermore, to remove all doubt, the SNB said “If necessary, it is prepared to purchase foreign currency in unlimited quantities ........and to take further measures as required”.

The main reason the SNB has not had too much trouble with speculators testing its resolve is because theoretically a central bank can print and sell as much of its own currency as it wants (in contrast to defending a weak currency where foreign exchange reserves are needed). This is the flip side of the SNB’s threat to purchase foreign currency in “unlimited quantities”. And if the currency printing is sterilised, there need not be any impact on the money supply. But despite its unequivocal language, the SNB has had to stand in the market from time to time, meaning it has accumulated large quantities of euros, so much so that it has become a major player in the Eurozone bond markets as it goes about finding a home for those euro holdings.

The economic reasoning behind the SNB's stand is clear enough: the European union is its biggest market and a strong franc threatens its export sector, something it can’t risk with economic growth forecast to be a feeble 2 percent this year. Furthermore, inflation is at rock-bottom levels and any further appreciation of the franc could tip Switzerland into a Japanese-style deflation. This accounts for Switzerland having an interest rate curve matched only by Japan, offering barely 0.60 percent for ten year bonds.

Chart: Monthly EURCHF chart

But if the rhetoric coming from the European Central Bank (ECB) is any guide, Eurozone interest rates could be headed in the same direction, courtesy of full-blown quantitative easing (QE). This would make the SNB’s job of maintaining the floor that much more difficult. A glance at the chart of EURCHF below (click to enlarge) shows that after peaking at 1.26 last May the cross has been gradually declining ever since and the 200-day and 50-day moving averages have both rolled over. All things considered, it is too early to declare “extra time” is over for the SNB, but if conditions in the Eurozone continue to deteriorate and the ECB president renews his vow to do “whatever it takes” to remedy the situation, then the Swiss resolve to defend the floor will face a stiff test.

Max McKegg - Managing Director / Technical Research Limit