12/09/2011: CHF and the "soon-to-be-busted" peg

Some weeks ago I have addressed one of the core reasons why the CHF/Euro peg, announced last week by the SNB will not hold for longer than 1-2 months. Here are the previous links to:

1. Small Open Economy argument (link)
   
2. Small Open Economy as safe haven argument (link)

Since then, in last weekend comment to the Sunday Times, I outlined another core reason for the peg to fail - the SNB has been brandishing the war chest of some USD 230 billion of FX funds that it says will be delivered into the battle field to support CHF, should pressures on CHF/Euro cross continue to mount. Now, that number above is roughly 1/2 of the Swiss 2010 end-of-year M1 money supply.

• Imagine the scale of intervention and the resulting interest rates hikes that will be required to extinguish inflationary pressures arising from this?Up by 50-100%?
• Now imagine what will happen with CHF cross with the euro if the interest rates in Switzerland were to, say, rise by 50-100%? Correct - demand for CHF will go through the roof, undoing any CHF/euro supports erected before.
• And alongside this, imagine what the 50-100% increase in interest rates do to capital investment and corporate balancesheets in Switzerland? Again correct - corporates, spared by SNB peg from being destroyed by the exchange rate appreciation will now face the very same FX pressures as before, plus higher cost of capital

And now, folks, for the third weighty reason why SNB will be forced to abandon its peg. Medium-term promise of a devalued CHF coupled with zero interest rates (0-0.25% on 3mo Libor target against Euribor 1.56% comp) implies a huge incentive for carry trades origination in very short term run, while in the medium-term, expected long-term revaluation of the CHF creates an incentive to make carry trades very short-lived. Both are not so much the forces to drive demand up, but the forces to destabilize fundamentals-determined medium-term FX rates.

Good luck betting that CHF peg holds, my friends...