Swiss cap crumbles *

The Swiss National Bank (SNB) removed the ceiling of 1.2 Swiss francs to the euro. It also cut its key interest rate from -0.25% to -0.75%. The Swiss currency immediately surged against the European currency (see chart at the bottom of this post).
An adjustment had already been made in December: the key interest rate had been lowered but there was no change on the ceiling .
This measure came as a surprise as, officially, the cap had been cited as a key component of Swiss monetary policy. There has since been a sharp shift.

This calls for several comments:
1 – This ceiling had been implemented on 6 September 2011 when the crisis was threatening the Eurozone. At the time, the Swiss franc was the safe-haven currency. To avoid additional appreciation, the SNB decided to introduce this cap. This measure was also prompted by the very low inflation rate at the time, so as not to import more disinflation.
2 – This defense of the currency resulted in a significant accumulation of reserves (see the addendum).
3 – The abandonment of this cap reflects the idea that there has been a change in regime for the euro :
A – This certainly reflects the increased likelihood of QE from the ECB (to be announced on 22 January?) particularly after yesterday’s remarks by the European Court of Justice.
B – Consequently, the equilibrium conditions between the two currencies will change. A main impact of the QE operation will be to cause a further depreciation of the single currency.
The question is therefore whether to maintain the 1.2 ceiling at all costs or to allow a new equilibrium to take hold between the two currencies.
The SNB chose the second option. It is letting the market determine the new equilibrium. Defending the ceiling was probably perceived as counterproductive as 1.2 was probably no more an equilibrium
4 – To offset the restrictive nature of the appreciation of the Swiss currency, the SNB decided to cut its key interest rate to -0.75%
Will the combination of the two measures result in a tighter or more accommodative  monetary policy stance than before the decision ?
It is difficult to say for now but it is a risky play.
After the currency appreciation, Swiss companies have dramatically lost price competitiveness and Swiss will import disinflation. This is not good news as the inflation rate is already in negative territory at -0.32%. The core inflation rate is just positive at 0.25%.
5 – This severely negative interest rate measure plunges Switzerland into a twilight zone, as the yield curve is negative out to the 7-year maturity and the 10-year maturity is just above 0.1%. (when the translation from French was done the 10 year interest rate was at -0.16% and the whole yield curve up to 10 year maturity was in negative territory)
6 – The Swiss measure came as a surprise but let’s not forget that the fall in the euro against the dollar reflects a deep change in what is by far the most frequently traded pair on the foreign exchange market. Each currency is, at some level, defined against this rate. The plunge in the European currency below 1.2 against the dollar and the possibility that it will plummet further, in light of the massive liquidity infusion that would result from the QE, will force each currency to reach a new equilibrium. There will be volatility on this foreign exchange market this year. Each currency will have to find its place and its new equilibrium.

SwissFrancAddendum to the French version
The following chart shows foreign reserve accumulation as % of GDP. In the third quarter of 2014 it was almost 80% of GDP. To make a simple comparison, the total Fed’s balance sheet represents almost 25 % of US GDP.
This is the source of Paul Krugman discussion on the Swiss situation. He said that the SNB monetary policy was a QE operation and that the size of accumulated reserves was perceived as too big to continue.
Swiss Reserves* The French version of this post was published on January the 15th

 

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s