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4 Reasons Why The SNB Will Keep Its Peg On EUR/CHF

Aug. 02, 2012 9:56 PM ET
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Earlier this week, rising bond yields in Spain and Italy stroked bailout concerns which consequently sent the euro to its two-year low against the dollar at 1.2042 and its 11-year low against the yen at 94.12.

Even though EUR/CHF stayed well above the 1.2000 handle, many traders still wondered if the SNB can afford to peg the franc to the euro as conditions in Europe deteriorate.

Remember that policymakers made the bold move last year in hopes that it would stabilize the economy. Some market junkies now say that perhaps the Swiss economy is already strong enough that its currency doesn't to be capped anymore. After all, Switzerland's GDP came in at 0.7% in Q1 2012 which translates to the strongest pace of growth since the third quarter of 2010.

That's definitely good news! But, if you ask me, you shouldn't get your hopes up for the SNB to abandon its peg anytime soon. Here are four reasons why:

1.Deflation is still a problem.

Recent data shows that Switzerland still struggles with deflation until now. In June, consumer prices in the country declined by 0.3%. Putting the figure in context, the CPI was down by 1.1% in June 2012 compared to a year ago.

Now, having a cap in place on EUR/CHF actually helps the SNB deal with deflation.

Keep in mind that Switzerland is an export-oriented country and the European Union is its biggest trading partner. This means that there is an excess supply of euros in the country since Swiss products are paid for in the foreign currency.

However, Swiss exporters need to convert their euros to francs in order to pay for their operational costs too. This should then boost the CHF, but since the SNB wants to keep it at a constant level, it increases the supply of domestic currency which consequently strokes inflation.

2.The SNB could realize more losses.

It was reported that the SNB lost 26 billion CHF in 2010 on its reserves when it allowed the franc to appreciate.

If it abandons its peg, it could suffer more losses as the Swiss franc would probably skyrocket following the move because traders would flock to the currency's safety. I haven't done the math, but I don't think the SNB would be excited to see its losses on its foreign currency reserves which reached record-highs in June at 365 billion CHF.

3.There are other options available.

Sure, the peg makes Switzerland vulnerable to the euro zone's problems. However, the SNB can hedge its risk by diversifying away to other assets.

Instead of ditching the peg, some analysts suggest that the SNB can just use its euros to buy other currencies or even German Bunds. That way, the risks to the central bank's balance sheets will be limited if a peripheral member of the euro zone should exit the bloc.

4.It would lose its credibility.

Taking off its peg on the euro virtually sends the SNB to the point of no return. Since the start of the year, EUR/CHF tapped the 1.2000 handle only once, reflecting the central bank's strong credibility.

EUR/CHF Daily Chart

However, should Swiss central bankers decide to take back their word, it's not likely for speculators to take the SNB's future acts of intervention seriously. That means that if the franc gets too expensive for Switzerland again, the central bank will need to get more creative than verbal and outright intervention to limit the currency's strength.

It seems to me that there are more pros than cons for the SNB to keep the franc pegged to the euro. And so, I wouldn't hold my breath to see EUR/CHF break down below 1.2000 just yet. But that's just me.

What do you think?

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