Swiss move signals end of the phoney war

YESTERDAY morning, the Swiss National Bank (SNB) took the bold move to put in place currency controls in the form of a minimum exchange rate between the euro and the Swiss franc at SFr1.20. The SNB said that it will protect the franc “with the utmost determination.” The SNB has also indicated that it is prepared to buy foreign currencies “in unlimited quantities.”

The SNB unsuccessfully made moves earlier in the year as it attempted to relieve the impact of the overvalued franc on the Swiss export economy.

One can understand the desire of the Swiss authorities to intervene in the currency markets. As central banks have meddled in the markets with money printing in the UK, US and Eurozone, investors have been left with only one feasible haven currency option: the Swiss franc. As a result, every sovereign debt crisis, and every whispered rumour of a further round of quantitative easing, has sent investors running for the safety of the Swiss currency, strengthening it more each time against its major currency pairs. This has hit Swiss exports hard. (see chart, above right) At the same time, Swiss interest rates have been lower than those in emerging markets in Eastern Europe, such as Hungary and Romania. As a result, many people took advantage of the advantageous borrowing rate to take out mortgages in Swiss francs. These borrowers were put to the sword when the franc began to rise, and default rates spiked. With Swiss, Austrian and German banks sitting on hefty potential losses, it is likely that this situation influenced the SNB’s policy decision.

However, up to now, the measures taken by the SNB have been futile. When it comes to currency intervention, it is for all intents and purposes impossible to reverse a strong currency flow. The only hope is usually to tip a change in trend when it is on the cusp of this reversal. “Currency pegs have never worked in the long term, and if it’s such a silver bullet, why haven’t the Japanese tried it given they have been trying for years without success to weaken their currency?” asks Michael Hewson, market analyst for CMC Markets.

PUSHING AGAINST THE TIDE
So what chance of success does this move have? One reaction to the SMB move is that it might compare to the move made by Norman Lamont and his adviser David Cameron in 1992, when the Bank of England spent billions of pounds buying up the sterling being sold on the currency markets as the UK tried to stay on the exchange rate mechanism. Then, the currency markets bet against Lamont, selling pounds and buying deutschemarks in successful anticipation of his failure. However, in this case, there is a clear difference. “The Swiss are protecting their currency from strengthening further rather than weakening,” says Chris Towner, director of FX advisory services at HiFX. “In order to protect your currency from weakening further, the market would immediately look at the volume of the foreign exchange reserves that the central bank holds, just as Soros and co did back in 1992 with the Bank of England.” Towner points out that the SNB is using its own currency as ammunition and so can be that much more bold – they own the printing press.

TRADING THE NEWS
Many of the big institutions had their stops blown out by the SNB move, and the shift yesterday morning will have done big damage to leveraged traders long Swiss franc. “One hundred pip moves in minutes in sterling-Swiss franc and euro-Swiss franc will have seriously hurt traders as they just gapped massively with no opportunities for stops to be filled on the way up,” says Ian O’Sullivan, head of marketing at SpreadCo. Interestingly, O’Sullivan adds that on Monday there was a lot of market chatter about interest in buying short-dated SFr1.14 calls for Wednesday expiry, looking like leaked news of the SNB move.

Any position taken by traders on the Swiss franc has to be seen as a position on the anticipated success or failure of the SNB move. “Either way, it’s an interesting trading opportunity, potentially,” says David Jones, chief market strategist for IG Index. If you take the view that the SNB is doomed to failure, the SNB has given traders an opportunity to go short on the dollar-Swiss franc 600 points higher than it was on Monday. If you think it is going to be successful then Jones points out that this is the start of a major trend reversal.

“It’s a massive gamble from the SNB and could prove very costly, especially if the tide doesn’t turn and the US goes down the route of QE3,” says Angus Campbell, head of sales for Capital Spreads. “Watch this space, but for now the upward trend for the Swissie remains firmly intact.”

Flashback: the 1973 Swiss Central Bank intervention

THOUGH the Swiss National Bank’s (SNB) recent move is a bold one, it is not the first time that the central bank has imposed currency controls in order to try and tame Swiss franc strength.

While financial turmoil in the US has driven capital flows into the Swiss franc today, four decades ago it was political and military problems. In 1971, as the cost of fighting the Vietnam war got out of hand, the US saw a sharp rise in inflation and the US was pushed into a trade deficit. After Nixon came off the gold standard in August 1971, markets weren’t convinced that the US government was serious about addressing its financial woes.

With low inflation, the Swiss franc was seen as a safe haven, and investors piled into the franc – sound familiar?

In 1973, the Swiss imposed capital controls, including negative interest rates on Swiss franc deposits by non-residents. (The Swiss LIBOR is currently -0.00333 per cent)

Though the measures were initially a success, within 6 months the franc had begun to strengthen again, with the dollar-Swiss franc hitting a low in 1978 of SFr1.50.