Interest Rate Differentials and the Swiss Franc 2.0

Photo by Roman De Bastiani on Unsplash

Punchline: In an earlier post, I found little evidence that the SNB–ECB policy rate spread drives the CHF/euro exchange rate, likely because the ECB’s unconventional policies make its policy rate a poor guide to its stance. Here, using euro area 2-year yields, I show that yield spreads do matter for the exchange rate.

I previously explored whether the spread between the ECB’s and the SNB’s policy rates helps explain movements in the euro/CHF exchange rate. This is a question I had occasionally looked at before but had never written about.

The motivation was simple. Many commentators — and often the SNB itself — describe Swiss monetary policy as being about setting an “appropriate” spread between Swiss and euro area policy rates. This makes sense because movements in the CHF–euro exchange rate have a major impact on the price of imports and, in turn, on inflation in Switzerland.

In that earlier post, I concluded that the evidence for a strong link was weak. Specifically, the spread between the SNB’s and the ECB’s policy rates does not seem to be a reliable indicator of how loose or tight monetary policy is in Switzerland relative to the euro area. I found that the slope of the Swiss yield curve (the difference between 10-year bond yields and the SNB’s policy rate), which is a measure of Swiss monetary tightness, did impact on the exchange rate. But I struggled to find a good measure for the euro area’s policy stance. Perhaps, I suggested, one would need to include a measure of the ECB’s QE programme or other unconventional policy measures, since policy rates alone only tell part of the story.

I also found that between 10-year euro area bond yields that reflected tensions within the euro area were significant.

Including 2-year yields

The problem with my earlier approach was that I could not identify a convincing indicator of monetary tightness in the euro area. My hypothesis was that the ECB’s heavy use of QE and other unconventional monetary policy measures weakened the link between its policy rate and its actual policy stance, making the policy rate a poor indicator of the tightness of monetary policy.

Economic theory suggests that exchange rates depend on expected differences in short-term interest rates between countries, not just now but far into the future. In theory, these expected differences should be reflected in long-term bond yield spreads.

But in practice, long-term yields are influenced by more than just monetary policy expectations. They also include various risk premia — the extra return investors demand for holding long-term bonds — which can reflect concerns about a range of factors, including interest rates, inflation, fiscal policy, and political risk. This means that a rise in long-term bond yields might signal either expectations of tighter monetary policy (which should strengthen the currency) or rising perceived risks (which should weaken it).

This brings up the practical question: what maturity counts as “long term”? In my earlier work, I used 10-year yields, but they seemed to have little explanatory power. That may have been because changes in risk consideration dominated changes in monetary policy expectations.

However, perhaps I had simply chosen the wrong point on the curve. Here I turn to 2-year bond yield spreads. I suspect shorter-term spreads mainly reflect policy expectations, with less influence from risk premia that can impact longer-term yields.

Let us first look at the different interest rates. The graphs below show the policy rate, the two-year yield, and the ten-year yield in Switzerland and in the euro area.

Source: SNB and FRED

Source: ECB and FRED

In Switzerland, the two-year yield fluctuates closely around the policy rate. It began rising ahead of the monetary tightening in 2022 and fell ahead of the easing in 2024. This is as expected, showing that financial markets broadly anticipated the direction of policy correctly.

In contrast, the ten-year yield moves much more over the period and seems to reflect factors beyond monetary policy expectations. For example, between early 2015 and early 2016, it fell from around zero to minus 0.5 percent. Since the SNB’s policy rate was already at a world beating -0.75 percent, it is hard to argue that this drop reflected expectations of further monetary easing by the SNB.

The pattern is similar in the euro area, though with an important difference: two-year yields were often below the ECB’s deposit rate. In August 2019, they were nearly 50 basis points below. This suggests that the ECB’s effective policy stance was more expansionary than the policy rate alone would indicate.

New results – yield spreads matter

Turning to the econometric analysis, as noted above, the regressions are run in difference form to avoid nonstationarity issues. I consider three measures of the relative monetary policy stance between Switzerland and the euro area: the spread between policy rates, the spread between two-year yields, and the spread between ten-year yields. Notably, the correlations between changes in these spreads are low, never exceeding 0.07 in absolute value. This shows that the three spreads are effectively uncorrelated and capture different information.

Re-estimating my earlier models, starting from February 2015 after the SNB abandoned the exchange rate floor, I find that the two-year spread is significant. The ten-year yield spread between Italian and German bonds remains significant.

Interestingly, and as theory predicts, the relationship is contemporaneous: changes in these interest rates affect the exchange rate at the same time, with no evident lag. Thus, when the interest rate spread changes, the exchange rate moves and settles at a new level.

In my earlier post, I found that the SNB’s policy rate mattered for the exchange rate. So maybe the policy rate works well at capturing SNB policy, while for the ECB it makes more sense to look at 2-year yields — since ECB policy was set not just through the policy rate but also through asset purchases, targeted long-term refinancing operations, and forward guidance. Estimating such a model I find that it fits the data slightly better than the model with 2-year spreads.

The graph below shows the results. Look first at the blue columns, which use the 2-year yield spread between Switzerland and the euro area. On average, the Swiss franc strengthens by about 0.1% per month. A 1% rise in the Italian–German 10-year yield spread — a proxy for euro area tensions — pushes the franc up by around 1.4%. And a 1% increase in the Swiss–euro area 2-year yield spread strengthens the franc by roughly 2.6%.

Source: My calculations

Now look at the orange columns, which use the spread between the SNB’s policy rate and the euro area 2-year yield. The main difference is that a 1% change in the spread now appreciates the franc by about 2.8%, slightly more than before.

These results imply that to predict the evolution of the exchange rate, one must form a view of future interest rate spreads – the current spreads are already fully priced in.

Summing up

In an earlier post, I found little evidence that the SNB–ECB policy rate spread drives the CHF/euro exchange rate, likely because the ECB’s unconventional measures make its policy rate a poor indicator of its stance.

Here, by using euro area 2-year yields, I show that yield spreads do matter. The bottom line is that differences in the expected monetary policy path between Switzerland and the euro area influence the exchange rate — but those expectations reflect not just current policy but also market views of future monetary policy that the central banks do not fully control.

The views expressed are my own. The work presented is preliminary and may contain errors. It should not be construed as investment advice. Readers are encouraged to seek professional investment guidance.