Swiss National Bank Sends Shock Waves Through Global Currency Markets

The Swiss National Bank has set an exchange rate cap on the Swiss franc (NYSE:FXF) in order to discourage investors from looking to the currency as a safe haven. The SNB will “no longer tolerate” an exchange rate below 1.20 francs to the euro (NYSE:FXE), and will keep the franc down by buying foreign currencies in unlimited quantities, according to an official statement released Tuesday.

“The current massive overvaluation of the Swiss franc (NYSE:FXF) poses an acute threat to the Swiss (NYSE:EWL) economy and carries the risk of a deflationary development,” reads the SNB statement. The Swiss economy has already been hit by the overvaluation of its currency, which has hurt exports from luxury watches to drugs, as they have become prohibitively expensive. The SNB’s move today has already pushed the value of the franc down 8.5% against the euro, and almost 8% against the U.S. dollar (NYSE:UUP) as of 6:51 a.m. EDT. Swiss stocks jumped on the news.

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“As the SNB’s pockets are very deep, it should succeed in stabilizing the rate above 1.20 (NYSE:FXE),” said Commerzbank economist Ulrike Randorf. However, “further depreciation of the franc seems unlikely to us in the current climate. Uncertainty on the market is still very high, with no sign of the debt crisis in the euro zone abating at present.”

A rate of 1.20 francs (NYSE:FXF) to the euro is still high, but the SNB said that it should continue to weaken over time. “If the economic outlook and deflationary risks so require, the SNB will take further measures,” said the SNB, which holds its quarterly monetary policy review on September 15. But as Randorf said, the SNB’s success in protecting the Swiss franc hinges on the euro zone taking decisive action to battle its economic crises.

In 1978, the SNB successfully defended a rate of 0.80 francs per German Mark, but the price was soaring inflation. “It worked in the short term, but it came at an enormous cost and led to a huge burst of inflation,” said Simon Derrick, head of currency research at Bank of New York Mellon, who expects the same may happen again.

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The SNB just recently reported that Swiss inflation had eased more than expected in August, declining 0.3% from the month earlier. After the SNB cut the interest rate on Swiss notes to zero on August 3, the franc weakened temporarily, but jumped last week as worries about the state of global economic growth intensified. The current measure is getting support from top politicians and business groups, as the franc (NYSE:FXF) has been given to extreme volatility in the last few months. Last year, the central bank was criticized for running up a huge loss in its efforts to tame the franc.