NEW YORK (
) -- The Swiss National Bank's pledge to set a EUR/CHF floor at 1.20 marks a new psychological defense against one-way euro bets, but not the end of Switzerland's currency war.
Having encouraged speculation about a currency peg in August, only to go through the 1970s arsenal of base money supply expansion, negative deposit rates and the threat of penalty rates after, the SNB had in effect encouraged speculation that its ability to weaken the franc is limited. Weaker global equity markets and an escalating euro area crisis into September called the SNB's bluff, bringing EUR/CHF towards the lower bound of the post-intervention corridor near 1.10 at the start of the week. This gave the SNB the psychological advantage of delivering on its ultimate threat of direct intervention, with intent and a target that will cause sufficient pain at the short end of the market to weaken the franc.
Arm-Wrestling With the Markets
Tuesday's move marks a shift in the SNB's strategy for a covert psychological war to open arm-wrestling. Herein lies the new challenge for the SNB. If the majority of the market had no incentive to buy the franc before a new peg level was established, now that the SNB has shown its hand, the game tactics change. Since the euro remains in a vortex of deteriorating structural, cyclical and financial systemic risks, the incentives for the market are now aligned one-way to sell the euro at the overvalued level set by the SNB. This will leave the SNB intervening in the market on a continuous daily basis to protect the peg, with volatile and disorderly euro capital markets only diminishing the SNB's psychological threat.
SNB Engineers Euro-Area QE
There is another more fundamental issue with the SNB's strategy. Since the onset we have believed that unsterilized purchases of core European government bonds is by far the most successful intervention tool that the SNB has. However the commitment to "unlimited quantities" means a massive monetization of European core government debt via the SNB's balance sheet. Purchases of peripheral bonds is possible but this is unlikely to constitute a viable sovereign wealth portfolio strategy, especially ahead of the October elections. This implies a steady convergence between German (two-year 0.454%) and Swiss (two-year -0.11%) interest rates, which will drive a diminishing yield disadvantage for the franc and further euro overvaluation. This in turn will stoke fears of a disorderly repricing of this pair once the marginal returns of the SNB's daily action in the markets decline.