Switzerland Watch – Deflation and recession

by: Georgette Boele

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  • We review the outlook following the removal of the EUR/CHF floor
  • The sharp CHF appreciation will likely cause more deflation and a drop in GDP
  • Our new EUR/CHF forecasts are: 0.95 (End March), 1.00 (end 2015) and 1.10 and 2016)

Swiss National Bank discontinued the floor in EUR/CHF

On Thursday 15 January 2015, the Swiss National Bank announced 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 investors completely by surprise. The market reaction was dramatic. At some point, the Swiss franc gained by more than 27% versus both the US dollar and the euro. Since the decision the effective exchange rate of the Swiss franc has risen by almost 22% (see graph below). The level is now above the 2011, high when the SNB introduced the floor in EUR/CHF at 1.20 after the Swiss franc rose by 26% in the period April-August 2011.

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Sharp rise in Swiss franc will cause more deflation…

In 2011, the sharp rise in the Swiss franc resulted in downward pressure on consumer prices. In the period April 2011 until June 2012, headline and core inflation dropped by 2.1 and 1.8 percentage points respectively from peak-to-trough. The strong Swiss franc had an important role in this, especially in the drop in core inflation. The larger drop in headline inflation was also due to the effects of a 22% lower oil price at that time.

This time around we can have a more detailed view about the impact of lower oil prices on headline inflation. The 50% drop in oil prices last year have only recently started to filter through to inflation. So far, it has shaved 0.3 percentage points of headline inflation. This was in a period that the Swiss franc was relatively stable. Most of the oil price weakness has not been reflected in headline inflation yet.  Meanwhile, core inflation has edged higher. The sudden rise in the Swiss franc will have a downward impact on headline and core inflation. If 2011 is of any guide, headline and core inflation will end up deep in negative territory.

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…and cause a sharp drop in exports

Swiss exports are 65% of GDP (around 45% of this goes to the eurozone) while imports are 52% of GDP. The sharp rise in the Swiss franc will cause a significant deterioration in the trade balance with exports dropping and imports rising.

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In the period 2010-2011 when the Swiss franc strengthened significantly, the contribution from exports to GDP dropped from 10 to -6.5% (see graph above). Swiss economic growth lost around 3 percentage points in 2010 and 2011. The economy continued growing, because domestic demand remained rather strong, which is less the case today.

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 …resulting in a technical recession at the end of 2015

Over the last two years, the net contribution of exports to GDP was around 1.6 percentage points when the currency was relatively stable. It is likely that the 20% increase in trade weighted index will push the contribution of net-exports to GDP to around -6 percentage points again. The domestic economy will likely continue to grow at a moderate pace and this will dampen the impact of the strong Swiss franc on the economy. It is likely that the Swiss economy will slow sharply in the course of this year ending in a technical recession followed by a recovery in 2016. As a result, the yearly average growth for 2015 and 2016 will be around 0.8% and 0.5% respectively.

New CHF forecasts

In the near term, it is likely that Greek election uncertainty could hurt sentiment and this will support the Swiss franc given its safe haven status. Meanwhile, quantitative easing by the ECB will continue to press the euro lower across the board. Therefore, we expect the Swiss franc to strengthen versus the euro to 0.95 at the end of March. Afterwards, conflicting forces could balance out, resulting in a relatively stable EUR/CHF. For starters, it is likely that the SNB will embark on more monetary policy easing to fight deflation and to support the economy. Meanwhile, the euro will remain under pressure because of ECB quantitative easing. What is more, positive investor sentiment should hurt the Swiss franc somewhat. As a result our new EUR/CHF forecasts for the end of 2015 and 2016 are 1.00 and 1.10 respectively.

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