This commentary originally appeared Jan. 25, 2012 on Real Money Pro – the ultimate traders' resource for actionable trade ideas and in-depth market analysis. Click here to learn more.
With the world's attention focused on the Fed meeting, the ongoing drama in Europe, earnings season and the World Economic Forum in Switzerland, it would be easy to miss some fascinating news items that recently crossed the wire involving the central bank of Switzerland.
As regular readers know, the Swiss central bank has been purchasing euros in order to maintain what it deems an acceptable exchange rate between Switzerland and the rest of Europe. The Swiss National Bank has declared that it will purchase unlimited quantities of currency in order to defend the 1.20 exchange rate between the euro and the Swiss franc. This essentially means the central bank has placed a stop on the exchange rate at 1.20. The current rate is just 100 ticks, or "pips," above that level, at 1.21.
This policy comes with some controversy because the SNB lost $24 billion on a similar gambit in 2010, when it tried and failed to prevent the EURCHF from breaking 1.50. That experience left a scar (which any trader will tell you is a side effect of losing a sizable chunk of your account).
Sufficiently chastened by the 2010 EURCHF debacle, it was assumed that the SNB would not revisit this policy; yet it did exactly that, declaring a 1.20 floor for EURCHF on Sept. 6, 2011. Most analysts assumed that the SNB would once again fail to maintain the desired exchange rate and lose billions in the process.
Not only did the SNB manage to avoid a loss in 2011, it surprised markets by reporting a $14 billion profit. Traders certainly liked the news, as shares of the SNB spiked higher by 15% on Jan. 13. (Some readers might be surprised to learn that shares of Switzerland's of central bank are publicly traded.)
Why is this significant? Currency traders have been gaming the EURCHF exchange rate, some trading with the SNB and some trading against the central bank. What the profit report should make clear is that the SNB's policy of buying euros is sustainable; this time around, the SNB is cashing in.
Like any trader might, the SNB has come up with a strategy to make back its earlier losses. With the current exchange rate trading just above the floor, the SNB could accumulate euros and then raise the floor, leading to even greater profits. There have been frequent rumors that the floor will be raised to 1.25 or higher. Why not accumulate euros and then raise the floor? If the policy is profitable, why would the SNB abandon it?
It appears that it won't. Yesterday, SNB board member Jean Pierre Danthine said the central bank would "continue to enforce the minimum rate with the utmost determination and remains prepared to buy foreign currency in unlimited quantities."
Then over the weekend, Johann Schneider-Ammann, Switzerland's economy minister, had this to say to Swiss newspaper SonntagsZeitung:
My minimum expectation is that the Swiss National Bank keeps the lower boundary of 1.20. In the midterm I expect purchasing parity to be re-established. It lies at about 1.40 francs per euro.
If Danthine is speaking the truth, there is little downside in EURCHF here, about 100 pips. If Schneider-Ammann is correct, the upside is 1,900 pips. The risk/reward on that trade would be 1 unit of risk per 19 units of reward.
I like those odds.
Even if we substitute a more realistic and attainable short term target of 1.24, there is 1 unit of risk per 3 units of reward. EURCHF last traded at 1.24 in early December.
If any of this sounds familiar, it should; we've been leaning on this floor since its inception, and continue to do so. EURCHF hasn't traded beneath 1.20 since the policy was established, and it is even less likely that the SNB would allow a breach of the floor to occur while the world is shining a spotlight on Davos.