Swiss Move Shows Central Bank Can't Operate in Isolation

Swiss National Bank’s game-altering move to end the Swiss franc’s ceiling against the euro creates challenges for its European counterparts, while traders are given a new safe haven option.

The lesson: No central bank is an island.

Three years ago, when the SNB capped the Swiss franc’s value against the euro, it diminished the currency’s traditional role as a parking space when other currencies were in trouble. That limited the options for a stampede of investors leaving the euro and later became an issue for those fleeing the Russian ruble.

Switzerland’s historical reputation for financial stability – and the fact that it was an advanced European economy outside the European Union – kept a modest money flow going there. But without the prospect of exchange gains, many money managers went elsewhere. Some went to traditional havens such as the dollar or the yen, others chased European alternatives like the Polish zloty, Swedish krona or Czech koruna. Those smaller central banks found themselves in the middle of a battle between two bigger players, the SNB and the European Central Bank. The latest development once again puts them in the crossfire.

In ending the 1.20 Swiss-franc floor at which it vowed to buy euros, the SNB blasted a dam and unleashed a monetary flood. Most eyes are watching where that flow is going: into the Swiss franc, which has soared versus the euro. But it’s also worth thinking about where it’s coming from. The euro is the obvious loser, but consider the zloty: Poland’s currency immediately dropped 21% against the franc in the aftermath, but also 2.2% against the dollar and 1.45% against the euro.

In truth, both Poland’s and Sweden’s currencies had been weakening against the euro well before the SNB’s latest move, which is saying something, given that the euro is down around 15% versus the dollar over the past 12 months. But their declines were an indirect result of the SNB’s interventions, which forced euro sellers into their currencies. That initially led to overvaluations, and prompted those countries’ central banks to tamp them down. The Swedish Riksbank slashed rates to zero and revisited the idea of negative rates it had first used during the global financial crisis. The National Bank of Poland employed a periodic intervention policy to push the zloty lower. Markets eventually got the message, but not before inflation in both countries, as well as the Czech Republic, was headed inexorably toward zero.

Now, these central banks must suddenly return to the drawing board. On Wednesday, Poland’s central bank announced it was considering cutting rates, a suggestion that it still thought the zloty was too strong. A day later it’s worried about a plummeting zloty. Polish rate cuts are likely off the table for now.

The fallout from this is a reminder that central banks never operate in a bubble – not the National Bank of Poland, not the Swiss National Bank, not even the European Central Bank or the U.S. Federal Reserve, though it’s always true that the actions of the bigger bank impact the smaller one more than the other way around.

In fact, the SNB policies over the past three years are direct responses to those of a bigger bank. The ECB’s struggle to, first, resolve the eurozone debt crisis and, then, to contain the regional economic deterioration, drove a steady flow of euros into francs. If that flow had been allowed to boost the franc’s valuation, it would have hurt Swiss exporters – hence the SNB’s imposition of a euro price floor. Ultimately, though, it was again the ECB that foiled the Swiss central bank’s policy. In hinting at a big new bond-buying, or quantitative easing, program, the ECB drove a new, large influx of euros into francs, so many that its Swiss counterpart could no longer keep buying them to maintain the CHF1.20 rate.

Today’s move “reflects the absence of central bank coordination” and the need for it, says Larry Goodman, President of the Center for Financial Stability in New York. “It shows how central bank policies radiate from the Fed to the ECB to the Swiss National Bank.”

– Follow Michael J. Casey on Twitter: @mikejcasey.