SNB miscalculates by dropping currency ceiling

The Swiss National Bank's decision to abandon its four-year-old EUR/CHF peg at 1.2000 is a stark reminder that in today's deflation-bound, zero interest rate world, capital appreciation exceeds yield.

Unlike in September 2011 when the Swiss franc's safe haven was boosted by the Eurozone debt crisis playing out in Italy, today there are several  nations whose benchmark interest rates or short term bond yields are below zero (Germany, France, Denmark, Switzerland and Japan). At the same time, the risks fuelling safe haven flows into the franc have increased (outright deflation in Eurozone, capital fleeing from Russia and EU uncertainty from the UK & GBP). These factors are likely to overcome negative Swiss rates.

In explaining its decision, The SNB mentioned the franc “overvaluation has decreased as a whole since the introduction of the minimum exchange rate”. Is that true?

Problem with divergences

Aware of the diverging monetary policies between the Fed and ECB, the SNB appeared to have decided to minimize the deepening franc decline against the USD as a result of maintaining the EUR/CHF peg in the midst of ECB/Fed divergence.

By removing the peg, the SNB decided to offset franc depreciation vs. USD with franc appreciation against the euro. But since 2/3 of Swiss exports are sold to the Eurozone, the problem of persistent franc appreciation against the euro could well outweigh any depreciation advantages against the USD.  Indeed, the US is Switzerland's third biggest export destination (behind Germany and China).

Dangerous assumptions

The SNB's assumption that further CHF weakness against the USD would ensue later this year and serve to offset CHF appreciation vs. EUR is based on the dangerously popular assumption that higher US interest rates are as inevitable as prolonged USD strength.

Since we expect the Fed will be forced to refrain from raising rates, owing to the emerging deflationary tide from China and Europe as well as the growth implications of these dynamics, the Swiss franc will be the last of the negative-yielders to depreciate against the USD – owing to its safe haven role from the Eurozone doldrums and Russian outflows.