In one of the wildest rides in recent memory, the Swiss franc went from being “the only sound money” in the FX market to the single most managed currency in the developed world. As the European debt crisis escalated, panicked investors from all across the continent sold euros and flipped their capital into Swiss francs, creating one of the most sustained price runs in FX market history. From its high of 1.1725 in June of 2010, USD/CHF declined in a near vertical fashion, all the way to its panic low of .7070 in August of 2011 – an almost unheard of 40% appreciation in the currency that typically moves less than 10% per year. After such unprecedented volatility the Swiss National Bank stepped in and did something that few markets participants thought would be possible – it created a currency peg that has remained in place for the past six months. Effectively, the SNB set a floor in EUR/CHF at 1.2000, stating that it will use all of the resources at its disposal to maintain that price level. From that point on, USD/CHF simply became a derivative of EUR/USD, falling and rising in tandem with the euro as EUR/CHF traded in a narrow 1.2200-1.2400 band for the rest of the year. In 2012, the critical question for the Swissie is whether the peg will hold. Presently, conventional wisdom believes that it will, but if the EZ debt crisis worsens, the Swiss franc could become the shock trade of 2012.
Controlling Market Psychology
In the multi-trillion dollar foreign exchange market where central bank intervention almost always fails often at a cost of many billions of dollars, it seems incredible that the SNB has been able to maintain control of the EUR/CHF price level with minimal impact to its balance sheet. The Swiss central bank merely had to hint that it was willing to print an unlimited number of francs to defend the 1.2000 level in EUR/CHF to spook the speculators off the bid. Since its announcement in August of 2011, the EUR/CHF has stayed placidly above floor level even as the debt crisis in Europe engulfed more and more states. Part of the SNB’s success had to do with the relatively small size of the Swiss economy and its concentrated trade activity with the Eurozone. Because 90% of Swiss trade is done with Europe, the SNB was able to command a tremendous amount of respect from the market as even the largest players accepted the fact that it could control the exchange rate in the currency. This psychological domination of the market has allowed the SNB to maintain the exchange rates at reasonable levels and even spur speculation that it could raise the floor in EUR/CHF to 1.2500 in early 2012. The SNB has been able to do this mainly though jawboning without actually spending much capital for intervention.
An Island of Stability amidst a Sea of Turmoil
Despite the rapid appreciation of the Swiss franc, the Swiss economy has been able to weather the storm in remarkably good shape. Swiss GDP declined from its 0.9% pace in Q4 of 2010, but remained positive, growing at 0.4% in Q1,0.5% in Q2 and 0.2% in Q3 respectively. Manufacturing did take a big hit as SVME PMI survey contracted for three months in a row, hitting a low of 44.8 in December, but surprisingly, the decline in demand did not translate into a loss in jobs as unemployment remained at a G-20 leading rate of 3.0%, actually improving from 3.1% the period prior. Nonetheless, retail sales clearly suffered as consumer sentiment turned cautious, contracting for the past two months in a row. Overall, however, the Swiss economy has been able to survive the vicissitudes of the exchange rate market relatively unscathed and looks to post small but positive growth into 2012.
The Fear of Deflation
While growth is a concern, the SNB’s greatest fear in 2012 is deflation. The latest CPI data has shown that the appreciation of the franc is clearly having an impact on price levels as inflation turned negative for the second month in a row. In fact, Swiss CPI has been negative for six out of the last seven months in 2011, suggesting that Switzerland is in danger of slipping into a deflationary cycle that could depress growth going forward for a considerable period of time. Fearful of the decade-plus battle with deflation that has plagued Japan, the Swiss monetary authorities take the issue very seriously and market speculation is that in 2012, they may try to raise the EUR/CHF level to 1.2500 to reflate the economy.
Can the Peg Hold?
Up to now, the SNB has done a masterful job of controlling exchange rates, but part of its success has been predicated on the market assumption that the euro will hold. In 2012, however, the sovereign debt problem that has been plaguing the continent for more than 18 months may finally cause the single currency to fracture if Spain and Italy are unable to refinance their debts at reasonable rates. Under such extraordinary conditions of market stress, the Swissie could once again become the safe haven of refuge for capital from Club Med economies and the massive flows could overwhelm the peg, breaking the 1.2000 barrier. Such a move could quickly cascade into an avalanche of sell orders and quickly push EUR/CHF to parity. The SNB would have to resort to its last available weapon – negative interest rates – effectively charging investors for the privilege of keeping their money in Swiss francs. Such a course of events would be even more extraordinary than the price fluctuations of last year and could make the Swiss franc the shock trade of 2012.
- David Morrison contributed to this article