What was the big deal in Switzerland last week?
Switzerland doesn't make it into the major global financial headlines often, which is very much how they like it. The news affecting global markets on Thursday originated from the Swiss National Bank abandoning its temporary Swiss franc exchange rate ‘peg' to the euro. This situation is detailed, and a bit convoluted, as we've already noticed a few errors in news articles in terms of what this and what it means.
First, some background on where this all started. Switzerland and the United Kingdom are generally the largest European nations not members of the European monetary union, so aren't using the euro as their primary currency. As we've discussed before about the characteristics that make currencies strong/weak, the Swiss have a reputation for playing things fairly conservatively and prudently, so, like the U.S. dollar and the Japanese yen, the franc has experienced a tendency of strengthening when global crises or slowdowns occur and investors seek out a safe haven. The difference is that Switzerland is much smaller than the U.S. or Japan, so large FX flows play a quicker and more significant role in currency fluctuations, which can result in disruptions that can carry over to other parts of their economy. This obviously presents some problems, which is why they play an active role in currency markets as needed to protect their interests.
In 2011, the SNB established a short-term policy in which it promised to print (i.e. sell) unlimited quantities of francs to buy euros, in order to keep the value of the franc from shooting any higher than it already was. (The specifics were the setting of a price limit of 1.20 franc/1 euro, or understood another way through its inverse of 1 franc/0.80 euro.) This trading of francs for euros as needed to reach ‘equilibrium' was done to help stem the tide of franc appreciation in the midst of poor prospects and depreciation influences in the Eurozone that were pushing the euro downward.
Unfortunately for the Swiss, this policy over the last four years has pushed the central bank balance sheet to over 85% of GDP—the largest in the developed world, even surpassing second-place Japan's high ratio. The Swiss also lowered the overnight deposit rate dramatically from -0.25% to -0.75%—the deepest negative rate a major central bank has ever undertaken. This was meant to be a partial offset, as lower interest rates tend to discourage currency appreciation, albeit it being a weaker tool than direct FX market buys/sells. In fact, even the Swiss 10-year government bond yield turned slightly negative (at -0.003%), which is the first time a large developed nation has experienced this is modern memory. (In another recent example of this policy—in an inverse way—Russia raised rates dramatically to help stabilize the ruble.)
Last week's unwinding move to remove the currency limit, of course, made the franc even more popular, causing it to appreciate over 20% within hours, to a 1 franc/1 euro ratio, representing one of the largest moves for a developed nation currency in decades. The Swiss stock market plummeted in response as a more expensive currency tends to depress exports (especially an export-heavy nation such as theirs) and increase deflationary impulses through cheaper imports. This is what's happened with the U.S. dollar lately, only to a far less severe degree. Again, markets hate surprises, since there always speculation about some hidden dire meaning behind the scenes. Some view this as a precursor to an inevitable ECB quantitative easing in coming weeks, which could have certainly pushed the value of the euro even lower than it is now and pressured the Swiss to keep buying euros.
In short, currencies appreciate when good things happen, and markets (as did perhaps the SNB) that potential euro deprecation from oncoming QE would overwhelm this regime, causing risks and costs to rise too high. After all, central banks are responsible for their own nation's interests first, and the rest of the world has to take a back seat. This is an unusual event, but not surprising given the trade-offs they faced. Being a fraction of the size of the U.S. and other major developed economies, the size of the franc market is far smaller and dynamics can't absorb extreme flows/policy changes without sharp adjustments like we saw last week. This is another odd byproduct of being a European nation and closely tied in with their neighbors for matters of trade, but not part of the official Eurozone currency union, as well as a highlight of the risks faced by relative small nations attempting tricky currency polices.
Read our Weekly Review for January 19, 2015.
Read the previous Question of the Week for January 5, 2015.