Swiss intervention threat to cap big franc gains

The franc rallied on Wednesday, after the Swiss National Bank expanded its sight deposits for the second time in a week to flood the banking system with more francs.

The measures fell well short of more radical moves that some analysts had expected, such as pegging the franc to the euro or announcing a floor to the euro/Swiss exchange rate, and this led to a brief spike in the franc.

It traded around 1.1440 per euro on Wednesday, and many in the market expect a test of 1.10 soon, but analysts say the SNB's gradual escalation strategy and threat of further franc-weakening measures will cap big gains beyond that.

"If we drop below 1.10 francs again alarm bells will start ringing," said David Jones, global head of FX capital management at National Australia Bank.

The franc surged to a lifetime high of 1.0075 per euro last week as investors, nervous about a deterioration in the euro zone debt crisis flocked to the currency, which outperforms during times of uncertainty due to its safe-haven status.

It sharply reversed that move, dropping 14.4 percent since Aug. 9, as investors speculated the SNB might be preparing to introduce a fixed floor for the euro against the franc.

Some are speculating it may set a target rate around 1.10-1.15 francs and do whatever it takes to ensure the euro does not fall below that.

Such talk and the constant threat of direct intervention are reining in the Swiss franc, for now, even as safe-haven flows stay robust, traders and analysts say.

But in light of the sharp turnaround in the franc since last week, some analysts say this strategy could prove to be an effective -- and cheap -- way for the SNB to deter investors and speculators from piling into the currency.

"If I were the SNB, I would just keep talking, because it's working," said Geoff Kendrick, currency strategist at Nomura.

"A 15 big figure fall on just talk? That's a good trade."

FLOORING THE MARKET

However, analysts said a significant rise beyond 1.10 would prompt the SNB to sell the franc directly on the spot market.

"The SNB will wait to see the impact (of recent measures), of which I don't think there will be any," said Chris Walker, currency strategist at UBS. "If we move down below 1.05 francs and towards parity, the next step will be direct intervention."

This would mark the SNB's first foray into the market since June 2010, when it ended a 15-month-long intervention campaign. In that time it racked up FX-related losses of more than 25 billion francs buying euros whose value has since plummeted while the franc has continued to climb.

The loss, along with inflationary risks of increasing franc liquidity, have held the SNB back from direct intervention, but if safe-haven demand keeps pushing the currency higher, it may have no choice but to intervene in the spot market.

The SNB's recent experience shows it may have to consider far more radical measures if it proves ineffective.

UBS anticipates the SNB will wait for euro/Swiss to break below parity before setting a fixed floor. Many analysts agree such a move would be a last resort, although this possibility may also keep investors from aggressively selling euro/Swiss.

While most analysts rule out a euro peg, Kendrick said the SNB had several options before resorting to setting a floor for euro/Swiss. These included deeper negative rates, through further increases to sight deposits, and taxing franc deposits.

The "nuclear option" would be similar to the one the SNB took in 1978, when it intervened to keep the German mark above 0.80 francs after a multi-year campaign of negative rates and capital controls failed to slow the franc's rise.

Setting that ceiling helped push the franc down more than 15 percent versus the mark through 1980, but as it also triggered a rise in domestic inflation, many consider the effort a failure.

Copyright Reuters, 2011