Markets have a short memory. A year ago many investors, including some of the biggest investment banks, were caught on the wrong foot with their short Swiss franc positions when the Swiss National Bank (SNB) unexpectedly lifted its cap on the currency, causing one of the biggest moves in foreign exchange markets since the collapse of the Bretton Woods system. Since September, the franc has stabilised in a range of 1.08 to 1.10 against the euro, and investors have been building up their shorts. Could the market be underestimating the risks again?
Admittedly, the likelihood of another big jump of the franc does not seem to be that great at the moment against the backdrop of slowly improving economic situation in Europe. But the broad collapse of commodity prices, economic weakness in the emerging markets and heightened geopolitical risks mean that another franc shock cannot be ruled out. The economic and political environment in the euro area is still fragile. Should growth slow down in the region or globally, this could trigger further easing measures from the European Central Bank, leading inevitably to more pressure on the franc. Continued market jolts, of which we’ve seen plenty over the last months, also only add to the risks for appreciation of the franc as a safe haven currency.
More importantly, if the franc were to appreciate strongly now, there is little the SNB could do to reverse it. The central bank lost about CHF 20 billion on its foreign-currency positions in 2015 alone. Large-scale interventions to weaken the franc would lead to a further swelling of its already bloated balance sheet, which in turn would only increase the likelihood of big swings in its future earnings. Not that the SNB needs to be making profits, but ballooning losses would only add to political pressure on the central bank. A loss of CHF 20.8 billion in 2010, when the franc strengthened as Greece was seeking its first bailout, led to calls for resignation of the central bank’s president at the time. The SNB estimated its total loss for 2015 would be about CHF 23 billion.
The SNB’s negative interest rates policy, currently a key instrument to prevent further appreciation of the franc, is also under pressure. With interest rates on sight deposits already at -0.75%, it’s unknown and untested how much more room the SNB has to lower rates further. At what level would the banks pass on this charge to regular savers? What would the Swiss do if they have to pay the banks interest on the money in their accounts? At what point would we see queues in front of cash machines? The scenario could be so catastrophic (essentially a collapse of the monetary and financial systems), that no central bank would ever want to test those limits.
Without means to stop and reverse the franc’s appreciation, the Swiss economy would see a further loss of competitiveness, higher unemployment, deflation and likely recession. For pressure on the franc to let up we would need a whole range of factors to fall into place: a steadying of commodity prices, a stronger Chinese economy, stabilisation in emerging markets and economic recovery in Europe and the US. The likelihood of such a positive constellation is certainly not greater than a black-swan event that would send investors piling into the franc.
With the SNB’s extremely limited room for manoeuvre, we can only hope that the interest rate differential between Switzerland and the euro area will not be decreased through actions of the ECB and that the pressure on the franc to strengthen for other reasons does not increase. Investors should not lose sight of the seemingly impossible and ask themselves: if the franc shock 2.0 comes, will I be ready?
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