Currencies: What to Watch for after the Swiss Surprise

Not too long ago, the Swiss National Bank (SNB) gave up the peg it had maintained for years between its franc and the euro. Market reaction was sudden. Within minutes of the announcement, the franc (or "swissie" as it is called in currency trading circles) rose almost 40% against the euro. Several articles in the financial media described these events as the start of a “currency war.” That is a catchy phrase. It is, however, misplaced. Recent and likely currency moves are much less a matter of targeted war-like policies than they are a reflection of economic and financial fundamentals that have and, for the time being at least, will continue to favor the swissie, and the U.S. dollar, over the euro and most other currencies. The only targeted currency policy was Switzerland’s efforts to keep its franc cheap, and the central bank’s action signals defeat, not the start of a war.

The Swiss Story
The story surrounding Switzerland’s action certainly is the most dramatic aspect of the currency picture. It began in 2011, when the eurozone’s ongoing fiscal-financial crisis prompted many to search for a safe haven from the euro. So between late 2009 and August 2011, money flooded into the Swiss franc, raising its value some 25% against the euro. Afraid that this appreciation would hurt Swiss exports and, so, the Swiss economy, the SNB decided to intervene actively in currency markets. By selling francs and buying euros to offset the pricing effects of other inflows, it held the franc rigidly at 1.20 to €1. Since Switzerland can, theoretically, create as many francs as it wishes, the presumption was that the bank could maintain such policies indefinitely.1

It is now, however, evident that it could not. The decision to abandon the peg seems to have grown most immediately out of the European Central Bank’s (ECB) turn to quantitative easing. Concerned over the threat of deflation in the eurozone and an intensification of the region’s fiscal-financial crisis, the ECB has earmarked some €1.14 trillion to buy bonds directly on European financial markets. The SNB could see that even a small part of such a flood of euros could overwhelm its sales of francs. The bank also may have abandoned the peg because it feared the inflationary effects of so much money creation and from following the euro down on global currency markets, though the ongoing threat of deflation in the eurozone would make such a prospect distant indeed. As it is, the sharp appreciation in the franc will tend to intensify deflationary pressure in Switzerland.2

Still, the SNB has not capitulated entirely. To dissuade people from buying its currency, it has driven down short-term interest rates a half-percentage point deeper into negative territory than they already were. Now, a depositor in Swiss francs must pay up to 1.25% interest for the privilege of leaving money in the bank. From the currency’s action recently, these negative rates are hardly discouraging enough to stem the tide seeking a safe haven in Swiss banks and in the franc.3

The Bigger Currency Story
If the tale from Zurich offers the most drama, the larger currency story concerns the rise in the U.S. dollar. Once written off as having lost its supremacy, the dollar has gained markedly during the past six months or so, jumping almost 18% against the euro and almost 12% against the pound sterling. The overall dollar index shows about a 15% rise against a composite of world currencies during this time. 4

As much as Europe may welcome the euro’s slide as a spur to exports and, hence, economic prospects, these currency moves hardly resulted from targeted policies. Instead, they reflect the more attractive environment offered in the United States for all sorts of investment. U.S. bonds, for instance, offer much more attractive returns. Yields on 10-year U.S. Treasury bonds pay 1.5 percentage points more than German government 10-year yields. Meanwhile, U.S. government finances, though hardly robust by historical standards, still look much less precarious than European finances, where most of the periphery still cannot shoulder their debt obligations without help from the European Union (EU) and the ECB, and where Greece has again brought up the prospect of debt repudiation or rescheduling. Relative economic conditions in the United States are similarly attractive. Recent strong U.S. real gross domestic product (GDP) growth may overstate the economy’s underlying strength, but the United States is definitely growing and considerably more robustly than the eurozone, where the economy can claim only a technical distinction from recession. Though British interest rates, finances, and economics more closely resemble those in the United States than they do the eurozone, its economic ties to the Continent tend to pull sterling along with the euro. 5

Since there is little prospect that relative economic and financial conditions will turn about anytime soon, it appears that the U.S. dollar will continue to gain going forward. The latest round of trouble with Greece will only increase European uncertainties and exaggerate the differences favoring the United States. If the U.S. Federal Reserve follows through with its promise to raise interest rates, it will add further to the yield spreads favoring the dollar.



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