People follow the development of courses in Zurich after the turbulence at the stock exchange on Jan. 15, 2015.
Today the Swiss National Bank shocked the world when it announced it would remove the cap it had in place to prevent the Swiss franc from rising too high against the euro.
Here's what that means and what it's all about.
Switzerland has a long reputation for having an incredibly stable financial system (everyone knows about its legendary banks). In 2011, during the scariest times for the euro zone, the country's safe-haven status turned the nation into an island of tranquility. Money poured into it from elsewhere in the euro zone as investors sought a safe place to park their cash.
Of course, with everyone wanting to have their money in Switzerland, the franc exploded in value. In early 2010 one franc was less than 0.7 euro. By the middle of 2011 the franc was nearly at parity against the euro, a massive move in a very short period.
Countries typically don't like it when their currencies zoom like that. The most obvious reason is that it's bad news for domestic exporters, whose goods become less competitive abroad. Switzerland is known for its high-value exports, such as watches and pharmaceuticals, so a surging currency isn't helpful. There are other reasons related to financial-system plumbing that create a problem for a country when a huge slug of foreign cash rushes in.
So in the summer of 2011, the Swiss National Bank announced a cap on the exchange rate between the euro and the franc. The euro wouldn't be allowed to weaken below 1.20 against the franc. The bank maintained the cap by printing francs on a regular basis to buy euros in the market to ensure that the currencies wouldn't breach that line. The cap held without a hiccup for more than three years.
So what happened today?
Without any hint that it was coming, the bank removed the cap, causing the franc to soar against other currencies.
"The minimum exchange rate was introduced during a period of exceptional overvaluation of the Swiss franc and an extremely high level of uncertainty on the financial markets. This exceptional and temporary measure protected the Swiss economy from serious harm. While the Swiss franc is still high, the overvaluation has decreased as a whole since the introduction of the minimum exchange rate. The economy was able to take advantage of this phase to adjust to the new situation. Recently, divergences between the monetary policies of the major currency areas have increased significantly – a trend that is likely to become even more pronounced. The euro has depreciated considerably against the US dollar and this, in turn, has caused the Swiss franc to weaken against the US dollar. In these circumstances, the SNB concluded that enforcing and maintaining the minimum exchange rate for the Swiss franc against the euro is no longer justified."
In a note to clients, Société Générale currency strategist Kit Juckes explains that the SNB came to the conclusion that it didn't make sense for it to keep on an endless path of buying more and more euros just to keep the currency down. And that perhaps the bank felt that all the euros it was accumulating on its ballooning balance sheet were becoming a liability.
Furthermore, the European Central Bank is seemingly on the verge of launching its own quantitative easing program, which should put more downward pressure on the euro and further increase the cost of holding the peg.
But don't expect the SNB to just do nothing now. Here's Juckes explaining that now we can simply expect them to change tactics (CHF is the Swiss franc):
The SNB is not ‘giving up' but rather, changing tack. After allowing the markets to clear, further intervention is likely—but possibly, in USD/CHF rather than EUR/CHF, with added emphasis on the CHF trade weighted index. After all, the marginal buyer of Swiss luxury goods nowadays is more likely to be in Beijing or Shanghai than Frankfurt or Paris. After that, the SNB will see what the effect of the new interest rate stance is, after all, such deeply negative rates will have an impact on the appetite of anyone to keep money on deposit in Swiss francs. The SNB must hope that the EUR/CHF, after settling at a much lower level initially, then drifts back upwards towards 1.20. A more realistic hope might be that the USD/CHF rate gets back above parity later this year.
So what does it matter to the world?
Well, whenever there are gigantic moves in any market, you can expect that a lot of people just lost a ton of money. There are other big ramifications in eastern European countries, where many people have mortgages denominated in francs. Those mortgages just got a LOT more expensive.
This shocker comes at a time when financial markets are experiencing a level of volatility not seen in a while. The collapse in commodities has already caused lots of pain. Now there's another out-of-the-blue move to add stress to the system.