The Swiss franc, one of the world's best known havens for safety-seeking investors, is now at the centre of a titanic battle of wills.
The Swiss National Bank has made a high profile vow to keep the franc from climbing in value. But so many investors are clamouring to buy the currency that it could be only a matter of time before the central bank caves, and is forced to allow the franc to rise.
The situation has currency speculators on high alert, sensing another opportunity to profit from a busted currency regime, much like George Soros's successful bet in the early 1990s against the British pound.
The upward pressure on the franc is being driven by the European banking crisis, which is causing skittish capital to flee financial institutions throughout the euro zone, into the relative safety of the Swiss currency.
Such capital flows have placed extreme upward pressure on the franc, damaging the country's competitiveness by creating an overvalued currency. Last September, the Swiss National Bank issued an ultimatum to foreign exchange markets: It pledged to do whatever is necessary to keep a minimum exchange rate of 1.20 francs to the euro.
At the time, the bank said it "will no longer tolerate" further appreciation and it would enforce its view "with the utmost determination and is prepared to buy foreign currency in unlimited quantities." This was unusually strong language from a central bank, a blunt statement to currency speculators that it would take them on, and prevail.
Now, the bank is being forced to back its words with deeds. The cost of maintaining the exchange rate against the euro, known as a "floor" among currency traders, is eye popping. Last month, as the European debt crisis intensified, the Swiss National Bank's foreign exchange reserves soared to 304-billion francs ($327-billion), a staggering 66-billion franc increase from April, as it bought unwanted euros to keep the franc's value in check.
Such purchases have continued this month. "We've heard that the Swiss National Bank is accumulating a billion euros a day due to its intervention," says Andrew Busch, global currency and public policy strategist at BMO's investment arm. He says the floor is "definitely" vulnerable.
The Swiss National Bank is taking huge risks. Its purchases could eventually end up fuelling inflation if the bank creates too much new money to buy euros, although that risk is small at the moment because the country is flirting with deflation. The bank is also exposing its balance sheet to enormous foreign exchange risk if the euro collapses. It's diversifying some of its purchases into other currencies, but this leaves it exposed to the value of the U.S. dollar and Japanese yen, among others, also risky bets.
"It's a very dangerous situation. At some point if they lose the fight then clearly they're going to lose a lot of money," Mr. Busch says.
Not everyone is counting on the Swiss National Bank being defeated in its effort to suppress the value of the franc, at least in the near term.
Currency and commodity expert Dennis Gartman, editor of the Gartman Letter, says the bank's currency floor "can remain in place far longer than you or I might dream possible."
He says the Swiss National Bank's efforts are far different from cases where central banks intervened to prop up overvalued currencies, such as the Bank of England and the pound in the early 1990s. Once these banks are out of foreign exchange, they have to allow their currencies to drop. In this case, the SNB wants its currency to decline and can "print all the money it needs to keep the currency weak," he says.
Camilla Sutton, chief currency strategist at Scotia Capital, believes the central bank will manage to hold the line. "I think the euro-Swiss floor is definitely credible," she said.
The huge foreign exchange reserve increases have caused some speculators to take positions in the franc, betting the Swiss National Bank will capitulate. Most bets are in the form of over-the-counter options that will pay out if the central bank stops defending its floor. Another approach is to buy Swiss franc futures contracts and simultaneously sell futures in euros.
Mr. Busch says that if the central bank abandons its floor, the franc will likely advance against other major currencies, presenting other trading opportunities.
The big question is whether the Swiss National Bank has been rattled by the massive currency inflows and the accompanying risks of holding too much foreign currency.
"If we see a repeat of the 66 billion [franc inflow] does it then become a political issue in Switzerland?" asks Ms. Sutton. "That's the only way that the floor becomes less credible."