Another day, another bout of extreme market turbulence. The last cue for mayhem has been the decision by the Swiss National Bank toabandon its attempts to prevent the franc from appreciating against the euro. Given that just a month ago, the SNB said it would hold the line with the “utmost determination”, the announcement took traders by surprise. The franc soared, the euro collapsed, shares lost their gains. It was uproar.
The reason the Swiss have thrown in the towel is pretty obvious. Mario Draghi finally seems to have convinced the Germans that quantitative easing is needed to prevent the eurozone from sliding into a potential damaging period of deflation, and the European Central Bank is likely to publish plans for a sovereign bond buying programme when it meets next week.
The SNB has close links to the ECB, and knows QE is coming. It may have been tipped off that the programme will be bigger than the markets are currently expecting. As a result, the Swiss authorities saw little point in continuing to buy euros in order to keep the value of the franc at a minimum of 1.20 against the euro.
The SNB sought to soften the blow by cutting its deposit rate to minus 0.75% in the hope that would deter investors from holding francs.
That looks unlikely. There are only three ways that QE can boost activity and raise inflation: it can provide the banking system with the financial resources to boost lending; it can increase the value of government bonds which leads to lower bond yields and cheaper long-term borrowing; and it can reduce the value of a currency.
In the case of the eurozone, it seems unlikely that QE will work through either of the first two channels, which is why the Germans question its worth. Eurozone banks are already awash with cash: they are either reluctant to lend or are finding that demand for loans is weak. Bond yields are already extremely low. So the only way the ECB is going to get inflation up is by pushing down the value of the euro. That will push up prices by making imports dearer and should also boost export growth. It is fair to assume that the ECB will continue doing QE until it gets the desired exchange rate effect.
For the Swiss, that’s a far from rosy prospect. Almost half its exports go to the eurozone and they are about to become ferociously expensive. The tourist industry, for example, will find that skiers in the winter and walkers in the summer migrating to cheaper Alpine destinations in the eurozone. For the moment, the SNB has decided that it can’t buck the market. But if it continues with the policy announced on Thursday, it will kill the economy. It won’t be all that long before it is once again actively buying euros.