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It looks like we have a unique positive-feedback cycle at work in the Swiss franc market right now.

As you may have noticed, the franc has surged since June, thanks partly to confidence in other major currencies deteriorating due to debt and money-printing concerns.

At the same time however, we've highlighted here before how consumers in eastern European nations such as Hungary and Poland had substantial exposure to Swiss franc-denominated mortgages. They took these franc-denominated mortgages in order to get lower interest rates, ignoring the currency risk involved.

The cycle. Yet as the franc now surges, it's forcing foreigners who have borrowed in francs, thus are short the Swiss franc, to unwind their borrowing. This creates additional buying demand for franc in the process, which makes the franc the stronger, forcing more borrowers to unwind, etc.

The two key market effects:

1) There are growing financial losses in Eastern Europe, especially Hungary given the nation's propensity for Swiss franc loans. An European Central Bank official has warned that Hungary faces 'acute risks' due to its own depreciating currency, which exacerbates borrowers' losses on a rising franc.

2) This positive feedback cycle means that the Swiss franc that has the potential for sharp rallies, well beyond what its 'fundamentals' (interest rates, Swiss GDP, etc) would imply in the near-term. Strength begets strength, in what amounts to a 'short squeeze' on Eastern European borrowers.

The cycle has a long way to go. While nobody is rushing to get a Swiss franc loan anymore, and people are unwinding their faulty gambles, the amount of franc loans outstanding is so large that the current unwinding process, and feedback cycle, likely has a long way to go.

For example, while the amount of Swiss franc mortgages in Poland fell 7% year to date, they still account for a whopping 60% of Polish mortgages according to Bloomberg.

In its latest quarterly review, the Bank for International Settlements (BIS) said,

Emerging Europe had borrowed more in foreign currency by the third quarter of 2007 than has been appreciated. Swiss franc loans represented about 20 percent of foreign currency loans. Ironically, currency flexibility encouraged Swiss franc debt, which has proven painful to obligors.

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