Soaraway Swiss franc threatens downturn and deflation

A massive leap by the franc bodes ill for a Swiss economy which is already flirting with deflation and relies heavily on its export base. After the Swiss National Bank abruptly dropped on Thursday the cap it had imposed on its currency for more than three years, the Swiss franc rocketed by 30% versus the euro. Trading later settled down but the franc was still up 15% more than four hours after the shock policy reversal.

SNB Chairman Thomas Jordan said the cap had been scrapped because it was unsustainable. The Swiss government forecast last month that the economy should improve on 2014 economic growth of around 1.8% over the next two years, albeit at a slower pace than previously forecast.

Mark Haefele, Chief Investment Officer of Swiss bank UBS, said the direct hit on Swiss goods exporters from the currency's lurch higher was estimated to be about 5 billion Swiss francs, equivalent to 0.7% of Swiss GDP.

Switzerland's economy is heavily oriented towards, about 50% of which go to the euro zone. At a stroke, they have become 15% more expensive.

Christian Levrat, president of Switzerland's left-wing Social Democrat party, called the abolition of the franc cap "a serious threat for tens of thousands of Swiss jobs". Nick Hayek, chief executive of Swiss watch firm Swatch, dubbed it a "tsunami" for exports, tourism and the wider economy.

The euro had plunged to 1.02 francs by 1415 GMT, way below the defunct 1.20 cap. "At levels close to parity many businesses and investment decisions might not be seen as viable anymore and over time a significant volume of economic production could move outside the country," said UBS strategist Beat Siegenthaler.

DEFLATION THREAT

Perhaps even more dangerous is the threat of importing deflation. If the Swiss franc stays 15% stronger against the euro, prices of imported goods will drop by that much. Swiss inflation is already running at 0.3% year-on-year and could be about to fall much further. In December, the government forecast prices would rise just 0.2% in 2015.

The SNB imposed the cap in late 2011 precisely to ward off deflation and prevent a recession.

While abandoning it, the SNB also sought to deter new flow into Swiss francs by lowering its interest rate on sight deposits, which was already negative, to 0.75%. Jordan said that would help ease upward pressure on the franc over time.

But with the European Central Bank expected to launch a large money-printing programme which should drive the euro yet lower, there is little prospect of the franc subsiding soon.

"With the ECB firmly set to bring down the euro, at least in the short term the franc is likely to rise, pushing Switzerland further into deflation and holding back exports," said Gabriel Stein, director, asset management services, at Oxford Economics.

As a result, analysts said the SNB would have no choice but to intervene on the currency market again, albeit differently.

"We're in an environment where inflation in Switzerland is at very low levels. This must be corrected," said Hans Redeker, global head of FX strategy at Morgan Stanley. "So in the next few weeks you will have the SNB coming back into play, but maybe their intervention will be concentrated not only in euro terms but in dollar terms as well."

Fitch's managing director of sovereign ratings Ed Parker said the move would not affect Switzerland's top-grade rating. "Clearly a change in monetary policy is an important event in terms of looking at what is going to happen to the Swiss economy but it is not a sovereign rating issue at the moment."