FX Watch – The SNB’s bombshell

by: Georgette Boele , Kim Liu

150115-FX-Watch-SNB-drops-a-bombshell.pdf ()
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  • SNB dropped a bombshell in discontinuing the floor in EUR/CHF…
  • …resulting in a 27% jump in the CHF versus the USD and the EUR
  • We expect further Swiss franc strength versus the euro
  • Big buyer of 2-5y euro sovereign bonds out of the market but impact limited

Swiss National Bank dropped a bombshell…

The Swiss National Bank announced earlier this morning a discontinuation of the minimum exchange rate of 1.20 in EUR/CHF and lowered interest rates by 50bp to -0.75%. This action took financial markets completely by surprise. There were some local media reports speculating in this direction last week, but investors had remained convinced in the SNB’s commitment to defend the floor.

… resulting in a dramatic market reaction

The market reaction was dramatic. At some point, the Swiss franc gained by more than 27% versus both the US dollar and the euro. Afterwards, it gave back some of these gains. At the time of writing, the Swiss franc was up by around 14% versus the euro and the US dollar. The collapse reflects that substantial stop losses were triggered below 1.20. Investors had taken for granted that 1.20 in EUR/CHF will not be broken.

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What were the reasons for this dramatic action (SNB)

What explains this dramatic decision? The SNB said that “while the Swiss franc is still high, the overvaluation has decreased as a whole since the introduction of the minimum exchange rate. The economy was able to take advantage of this phase to adjust to the new situation.

Recently, divergences between the monetary policies of the major currency areas have increased significantly – a trend that is likely to become even more pronounced. The euro has depreciated considerably against the US dollar and this, in turn, has caused the Swiss franc to weaken against the US dollar. In these circumstances, the SNB concluded that enforcing and maintaining the minimum exchange rate for the Swiss franc against the euro is no longer justified”.

This reasoning is difficult to understand given the effective exchange rate has remained historically high.

There goes the SNB’s credibility…

We think that move represents a major miscalculation by the SNB and an enormous policy blunder. It stated that “it is lowering interest rates significantly (by 50bp) to ensure that the discontinuation of the minimum exchange rate does not lead to an inappropriate tightening of monetary conditions”. Today’s market reaction is certainly doing that. It is a complete miscalculation that a 50bp rate cut would be enough to avoid a dramatic strengthening of the Swiss franc. Moreover, the SNB is putting its credibility at stake. First, the market will think twice if the SNB communicates that it is committed to doing something. Second, where is the strategy to fight deflation? Last week, CPI came in below market consensus at -0.3% yoy. Core inflation rose, but is still only 0.3%, following a long period of falling prices not too long ago.

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Some say that last week’s announcement of significant SNB profits for 2014 may have something to do with the timing, because it will provide a cushion against the mark-to-market losses. What about the negative impact on the economy, which has now to endure a massive headwind on its exports and to cope with even stronger deflationary forces? In short, the SNB made a miscalculation and it will take a long time to restore credibility.

Change in outlook for the Swiss franc

In the near-term we expect the SNB to try to stabilise the Swiss franc via even lower interest rates, quantitative easing or FX intervention. If today’s announcement is of any guide, the SNB will probably not take the FX intervention road. Taken the recent price action into account, it is safe to say that the majority of stop losses and option barriers have been taken out. So another wave of Swiss franc strength will come from investors actively buying the Swiss franc and taking new positions. This will most likely happen in the coming months. So after some kind of stabilisation, Swiss franc is likely to strengthen. We are obviously reviewing our current forecasts

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Big buyer of 2-5y euro sovereign bonds out of the market but impact limited

The discontinuation of the minimum exchange rate policy will lead to changes in the SNBs investment strategy. The policy change could result in discontinuing investments in foreign currency reserves, and in particular euro denominated assets. Up to now the SNB intervened in foreign currency markets by increasing its asset investment portfolio. More concretely, the SNB invested significant amounts in highly rated euro denominated sovereign bonds. If the SNB discontinues its investment policy, this would lead to a decline in euro denominated exposure. Given the investment duration of the SNB portfolio of 4.0 years, this could lead to it stopping investment in 2 to 5 year maturing sovereign bonds. Since AAA and AA rated bonds together sum up to 92% of all investments in fixed income assets, the market should expect significant amounts of short maturing sovereign bonds coming to the market. We would assume that the bulk of these assets primarily consist of German and Dutch bonds, given the higher liquidity of these markets, compared to Finnish and Austrian bonds. However, the impact German and Dutch bond yields is likely to be limited given other sources of demand and scarcity of high quality sovereign debt

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