Swiss National Bank vs. ECB: The Best and Worst of Central Banking

swiss national bankThe Swiss National Bank's three-year-old franc-euro peg is no longer.

Yesterday (Thursday), the Swiss National Bank decoupled its fixed 1.2 CHF/€ exchange rate. This was on expectations that the European Central Bank will announce a quantitative easing policy in next week's meeting.

"This is the best and worst of central banking at the same time," said Money Morning Chief Investment Strategist Keith Fitz-Gerald. "Clearly the Swiss are looking at the looming European Central Bank stimulus program and have simply decided they don't want to tie their currency to a sinking ship."

You see, for more than 50 years, the Swiss franc has been the symbol of a stable currency. You would be hard-pressed to find a currency that has appreciated more than the Swiss franc in its history.

The Swiss franc always seems to appreciate when other currencies falter. This has been true through terrorist attacks, global financial turmoil, and natural disasters.

"The Swiss have always put a very large priority on price stability," John E. Marthinsen, a professor of economics and international business at Babson College, told Money Morning. He's also the distinguished chair in Swiss economics of the Glavin Center for Global Entrepreneurial Leadership, and he co-authored the book "Swiss Finance: Capital Markets, Banking, and the Swiss Value Chain" in 2012. "The financial system has done a very good job earning a reputation as a very safe place to put to your money."

Here's why the Swiss employed a peg in the first place...

Why the Swiss Franc Was Pegged to the Euro

It was the reputation of the Swiss franc as a safe-haven currency that first made this policy necessary.

In 2008, the global financial system collapsed. And not long after, the Eurozone was gripped by a number of sovereign debt crises. Everyone fled to the reliable Swiss franc and an appreciation followed.

But this appreciation proved more than the Swiss National Bank could handle. Swiss exporters were losing out as their goods became more expensive against their key trade partner, the Eurozone.

"The Swiss National Bank realized that it was handicapping business that had been around for a long time," Marthinsen said. "They didn't want them just being destroyed by short-term debt problems."

In September 2011 the SNB reversed course. They announced that they would maintain a peg of 1.2 CHF/€.

Essentially, if it fell below 1.2, the bank would intervene. The SNB would buy euros on the market and sell Swiss francs. It would do the opposite if it broke above 1.2.

But lately, the euro has been falling - a lot. It's fallen so much so that it has been routinely crashing through multiyear lows. The SNB's announcement has the dollar rising to 11-year highs against the euro today.

It's not hard to see why. The most recent data shows that in the Eurozone, the unsettling trend of disinflation has turned negative. The Eurozone is in deflation.

This is the last thing the ECB needs. The region has, for a while, been plagued with one sovereign debt crisis after another. A prolonged deflationary cycle only adds to the real value of its struggling countries already elevated debt loads.

ECB president Mario Draghi has made it obvious that he wants Eurozone QE. And speculators have been shorting the euro. They want to get ahead of an even larger QE-fueled deflation that will inevitably happen after Draghi gives the go-ahead.

And the ground is becoming more fertile. European Union lawyer Advocate General Cruz Villalon said the ECB's planned bond-buying program is legal. This is despite German challenges and EU treaties that forbid the ECB from financing member countries' debts.

And next week, the ECB is meeting for its policy meeting. The SNB is readying for Eurozone QE.

And they want nothing to do with it...

The Swiss National Bank Cuts Its Losses

The SNB didn't want to keep flooding its balance sheet with assets that are set to lose value.

"Considering the SNB's holdings of foreign exchange reserves have doubled since the peg was instituted, and ECB QE would have meant buying hundreds of billions more euros; its already massive balance sheet would have swelled even further," Money Morning Resource Specialist Peter Krauth said.

"The peg simply became untenable for the SNB, which took a huge loss on its euro reserves as they tanked relative to the franc," Krauth said. "Had they decided to maintain the peg longer, it would have meant an even larger balance sheet, and even more risk of a larger loss in the future."

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Despite the initial panic in the foreign exchange markets - and the sinking euro - this move will end up balancing itself out.

"The Swiss are initially going to realign toward the dollar and there's going to be a lot of volatility surrounding this as traders shed the risk they had previously arbitraged away. Then, it will be right back down to business," Fitz-Gerald said.

While "this will be just another blip," Fitz-Gerald added that with the Swiss unpegging from the euro, that "blip" is actually a "pretty damning indictment of big central banking for the moment."

As for the euro, "this is possibly a signal that the euro is about to experience another big leg down, assuming QE comes," said Krauth. "Any drop, however, will not be as big as some expect given the considerable weakness in recent months, which was likely already pricing in QE."

The Bottom Line: Obviously, this move has had some big implications for the foreign exchange market. The Swiss franc soared more than 20% against the euro in just one day. But you'd be better off not trying to play the currency markets right in this moment.If you don't have a short position on the euro, your best bet right now may be to wait until a QE announcement. Then you can act. The European markets are sure to get a QE-fueled boost, and you can play it with the Wisdom Tree Europe Hedged Equity ETF (NYSE Arca: HEDJ). It provides the most liquid claim to European stocks and hedges against a weakening currency.


The Euro Still Has a Ways to Fall... In fact, in as little as 15 months it could achieve dollar parity. To see what is going to keep the euro in free-fall for the long-term, take a look at our 2015 euro forecast...