January 19, 2015

Swiss National Bank scraps peg to Euro amid economic uncertainty

The Swiss National Bank eliminated its cap on the euro-franc exchange rate Jan. 15, at a time when the global currency markets are experiencing sharp volatility and central banks across the world are using increasingly divergent monetary policy.

Swiss National Bank currency peg
Until last week, the SNB had purchased foreign currencies to ensure the euro would buy no fewer than 1.2 francs. The SNB instituted this policy in 2011, as a brewing eurozone debt crisis drove people across the region to deposit their money into Swiss bank accounts, according to The New York Times.

This flight to Swiss bank accounts caused the franc to appreciate substantially, and between the start of 2010 and halfway through 2011, the currency rose 44 percent versus the euro, The New York Times reported. Switzerland's businesses suffered because of this dramatic increase, prompting the SNB to bring the exchange rate under control. The central bank started out by cutting interest rates, but soon took to the open markets, buying the euro to meet its desired exchange rate.

A new approach
While this strategy worked for several years, the increasingly severe fluctuations in the global currency market have made it more costly to maintain the currency peg, and the SNB recently announced it would take a different approach, according to The New York Times.

At the same time the SNB revealed it was abandoning its efforts to ensure the euro-franc exchange rate, they reduced interest rates significantly to ensure adequate monetary stimulus.

The SNB divulged these plans at a time when market participants around the world are expecting the European Central Bank to soon initiate its latest round of quantitative easing. The ECB may begin purchasing the government securities of nations in the euro zone.

Diverging central bank policy
While this would mean two central banks in Europe are using monetary easing, the U.S. Federal Reserve is getting ready to increase its benchmark interest rate. Market participants have been monitoring the statements of Fed officials for months in an effort to obtain greater clarity on what timeline the organization will use to hike interest rates.

Previously, the central bank indicated it plans to increase these rates around the middle of 2015, according to The New York Times. While economic conditions have been improving, Fed officials stated last year that lackluster inflation could prove challenging in the short-term.

In the current environment, interest rates are more likely to remain low for the first six months of this year, which will keep prices on loan portfolios high for now. However, if these rates move higher, the price of these portfolios will decline. As a result, financial institutions that have these assets should consider selling them sooner rather than later.