Swiss Surprise: National Bank Ends Currency Cap
On Jan. 15, the Swiss National Bank (SNB) unexpectedly abandoned its policy to cap the value of the franc at 1.2 euros.1 Over the past few years, the SNB has had to sell billions of francs to buy euros to prevent an excessive appreciation of the domestic currency ― a too-strong currency could dent the country’s export business. The prospect of quantitative easing (QE) in Europe raised the prospect of more franc sales, more euro purchases, and the significant risk of potentially large foreign exchange losses for the SNB. It therefore changed tack by abandoning the cap but cutting official interest rates further to -0.75% from -0.25%.1 As a result, the franc has appreciated 17.5% versus the euro and 16.5% versus the US dollar,2 although we believe there could be further volatility ahead.
What are the implications?
Interest rate markets:
Overall, we believe the move should have a positive impact on European rates markets. After the SNB printed francs and bought euros, it would recycle the euros into short-dated government bonds. Although the SNB is now stepping away from that process, negative interest rates in Switzerland could lead money to leave the Swiss banking system and find its way into other bond markets with positive nominal yields (and probably longer duration than the markets where the SNB was buying). Moreover, foreign assets have suddenly become much cheaper in Swiss franc terms.
Currency markets:
On the currency side, the SNB was one of the biggest buyers of euros in the market, so the euro has weakened. The market has also assumed that the SNB caught wind of what the ECB is planning in terms of QE and sold euros on the back of this. The trend for a weaker trade-weighted euro was already in place, and this could exacerbate those selling pressures. The euro appears to be the key funding currency (i.e., the best currency to sell to fund long currency positions) and we believe this is a clear negative for the euro.
Swiss economy:
We expect the largest negative impact will be on Switzerland itself. Inflation is already running at -0.3%3 year over year, and a strong currency could push it deeper into negative territory. The central bank has lost credibility in its battle against deflation, so it will probably need to take deposit rates even lower, and Swiss bonds could soon have negative yields out to 10-year maturities. Meanwhile, we expect Swiss companies with large foreign earnings to see Swiss franc profits reduced, and Swiss stocks were down sharply on the announcement (in Swiss franc terms).2 It will also be important to watch for any idiosyncratic risks, such as the collateral impacts of Swiss franc carry trades being unwound.
1 Source: Swiss National Bank
2 Source: Bloomberg LP, Jan. 15, 2015
3 Source: Swiss Federal Statistical Office
Important Information
Idiosyncratic risk is specific to an asset or a small group of assets and has little or no correlation with market risk.
Carry trade is a strategy in which traders borrow a currency that has a low interest rate and use the funds to buy a different currency that is paying a higher interest rate.
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Many countries in the European Union are susceptible to high economic risks associated with high levels of debt, notably due to investments in sovereign debts of European countries such as Greece, Italy and Spain.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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