Northern Country

How globalization changes capitalism, the economy and politics

National Bank intervenes to weaken the Swissi

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A picture is worth a thousand words. From 1750 to around 1900 price levels in England remained fairly stable. In the beginning of the 20th century prices took off bringing the first bout of major inflation during the roaring twenties, followed by a longer stretch of deflation during the Great Depression. Later price levels accelerated and never looked back to this day.

In 1914 the Bank of England to finance military operations during World War I suspended the gold standard, a monetary system where paper money is convertible to fixed quantities of gold. In 1925 after several years of significant inflation the British government returned the pound to the gold standard. The subsequent rise in demand for gold on conversion payments attracted major currency outflows from the US causing a serious contraction of money supply.

In the 1930s the beginning of the Great Depression prompted the British government to finally abandon the gold standard. After the Second World War only the US was upholding it by fixing the price of gold at $35 per ounce. In 1944 the Bretton Woods Agreement established a new monetary system by mandating fixed exchange rates between major national currencies. The US dollar remained pegged to the gold standard.

Major expenditures and the Vietnam War caused enormous fiscal strain to the US government. The balance of payment crisis that ensued led president Richard Nixon to abandon the gold standard in 1971. From there on a system of exchange rates based not on gold but rather fiat money was accepted as legal tender. In 1976 all major currencies followed a floating regime of exchange rates. This new system of fiat currencies enabled central banks to use interest rates rather than exchange rates themselves to meet certain targets of price stability.

The Nixon shock of de-pegging the US dollar form the gold standard caused a series of significant monetary and economic problems in the United States and its trading partners. In an attempt to revive the US economy the Plaza Accord was signed in September 1985. Several US trading partner agreed to let their currencies appreciate in favor of a weakening dollar. It was the first major combined intervention in this relatively new system of floating fiat currencies.

Under the free floating regime exchange rates should be determined by capital flows in currency markets with interest rates, the cost of carry and fiscal policies being the major monetary toolkit by central banks. Time and again since the Plaza Accord several countries have more openly or not intervened in currency markets to benefit their balance of payment accounts, prompting the emergence of the term managed free floats.

In general such interventions are doomed to fail if currency speculators are betting against it. Billionaire investor George Soros in betting against the British pound forced the Bank of England to withdraw its currency from the European Exchange Rate Mechanism.

First time since 1992 the Swiss National Bank has recently launched a preannounced series of currency interventions. Policy makers intend to hold down the franc in an attempt to counter deflationary pressures. In June consumer prices have dropped 1 percent from a year earlier and GDP has contracted 0.8 percent in the first quarter of 2009.

The reversal of carry trade, the borrowing of low-yielding currencies in exchange for higher-yielding assets, considered to be a major concern has led to the appreciation of the Swiss franc during the global credit crisis. Although in the months since March diminishing somewhat, this correlation is still pretty strong and the SNB is countering these forces by selling its own currency in open market operations.

The first intervention confirmed by the central bank was on March 12. That day the franc fell by a record one-day drop of 3.26 percent against the euro. According to traders the bank intervened several times since then but only confirmed another major open market operation on June 24.

SNB board member Jordan reiterated the bank’s commitment to prevent the franc from appreciating too much. Between 2006 and 2008 the franc traded at 1.61 per euro on average therefore traders might be looking at further depreciation of about 5.6 percent in the currency.

“The markets so far have well understood what our intentions are”, Jordan said in a July 2 interview. Currency traders have cut back on their bullish bets. Implied volatility on franc call options exceeds that of put options by only 4 basis points, the lowest level since 2007. On July 17 before the intervention, premium for call options to buy the franc was still 23 basis points.

On the downside for the Swiss bank is a continuing slump in the global economy, with a sustained output contraction well into 2010. This coupled with major risk aversion could bring the franc back into focus and render the bank’s intervention unsuccessful. How intervention does not always work proved the Bank of Japan which saw the yen appreciate about 15 percent despite major intervention between 2003 and 2004.

SNB is also concerned about not depreciating the franc too much since this could be construed as a “beggar thy neighbor” policy and put major trading partners in an unwelcomed disadvantage. The banks goal is to stabilize the franc at a level not acutely hurting the European currency.

Naturally forecasts about the near to medium term EUR/CHF currency cross are difficult but a trading range between 1.51 and 1.61 over the next 6 to twelve months seems reasonable. The SNB is expected to defend the 1.51 level in the EUR/CHF cross given the history of the most recent interventions.

This graph shows the 2 major SNB interventions (March 12, June 24) and subsequent jump in EUR/CHF cross:



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