Further SNB intervention likely, but possibly in USD/CHF

Outlook:

We get various economic indicators this week (see the Econoday calendar on the last page), along with earnings reports, but let’s be realistic—the big news is the ECB meeting on Thursday and the Greek election on Sunday, plus the fallout and autopsy of the Swiss National Bank decision to unpeg the franc from the euro. It’s a little funny that the ECB decision is so over-bought, so to speak, that yesterday French Pres Hollande said the ECB would announce QE on Thursday, as though it is a fait accompli. The ECB declined comment.

Switzerland first. We must assume that capital flight into Swiss francs, both ongoing and expected, was a prime motivator of the SNB in taking last week’s unpegging action. Russia, Greece—take your pick. SocGen’s Juckes, who knows a hawk from a handsaw, points out that “The SNB is not ‘giving up' but rather, changing tack. After allowing the markets to clear, further intervention is likely—but possibly in USD/CHF rather than EUR/CHF, with added emphasis on the CHF trade weighted index. After all, the marginal buyer of Swiss luxury goods nowadays is more likely to be in Beijing or Shanghai than Frankfurt or Paris. After that, the SNB will see what the effect of the new interest rate stance is, after all, such deeply negative rates will have an impact on the appetite of anyone to keep money on deposit in Swiss francs. The SNB must hope that the EUR/CHF, after settling at a much lower level initially, then drifts back upwards towards 1.20. A more realistic hope might be that the USD/CHF rate gets back above parity later this year.”

Maybe not. See the mini-chart below. This shows the CHF/EUR (monthly) so that it’s the CHF that is on the rising trajectory, as the Swiss think of it. We drew a standard error channel from the low in Nov 2007 to the spike high in Aug 2011 and extended it out by hand. For April 2015, the linear regression lands on 0.9765. It hits parity in September. But, and it’s a big caveat, FX traders always trade way ahead of the trend. As the jokesters say, “we anticipate.” So, if the Chf/Eur hits parity well ahead of the summer, as it may well do, how much higher will it go by year-end? The channel top is 1.0620 at year-end, but the spike high is a possible target at 1.1454. At a guess, nobody will be shorting the Chf against the euro for a long time to come.

And we must acknowledge that the euro is going to depreciate. This is what Mr. Draghi wants and needs. After all, the EMU is a monetary union, not a fiscal union, and it would take fiscal changes to trigger the real structural changes that is needed to get the economic boost the ECB is seeking. The announcement effect of QE will be nice but severe doubts have been raised all along about how effective QE will actually turn out to be, given conditions (banks unwilling to lend, small bond markets, etc.). The size of the program—more like €2 trillion than the €500 billion being bruited out (25% of €8 trillion of sovereign debt outstanding) might have an announcement effect of its own, too. But depreciation is the top tool, not announcement effects.

The SNB knows depreciation is the only mechanism available today to boost the eurozone economy. When one of the judges on the European Court of Justice seemed to open the door to QE by approving bond purchases as “appropriate monetary policy,” the SNB could see the handwriting on the wall for its current trove of euro reserves as well as the cost of looming intervention needs. Why buy a depreciating asset? Mr. Jordan decided that he was digging himself into a deeper hole and it was time to stop digging.

This is a sane and reasonable decision, and too bad for the speculators who failed to appreciate that a stop is always a market order and prices can gap right over your stop. You will get filled 1000 points away, not 50 or 100. Those who lost their shirts are calling it a “black swan” event. It’s not. We have had many occasions in when a currency put in a huge gap because of an institutional change. When the cap was announced (Sept 7, 2011), the USD/CHF went from 0.7869 at the open to 0.8612 at the close or 743 points.

Black Wednesday in Sept 1992 when sterling left the ERM was 1050 points (1.8755 at the high on Sept 16 to 1.7705 at the low). Critics may say these events come along only every couple of decades, but how big a gap do you need to get wiped out? The point is that the FX market has more institutional risk than equities and commodities--after the bond market, which has the most. Institutional risk con-verts to execution risk immediately and to the power of whatever leverage in play.

Some chart readers claim they could see it coming. We’d be surprised if that was true. Good management (less leverage and a diversified book), maybe, but to forecast the SNB would abandon the cap and on a weekday? Doubtful. We have no hard reasons to think we could have or should have known what the SNB would do. There were no leaks from the SNB and the decision was a surprise to everyone. The SNB paid for the cost of the sovereign debt crisis, including Grexit—why would they not pay for QE, too? After all, a weak Chf that is tracking the euro is VERY good for Swiss exporters. Even in retrospect, we can’t say “we should have seen it coming”—not like the crash of the subprime market in 2008 , where plenty of people saw it coming. Read Michael Lewis’ The Big Short. If no traders saw it coming, it can’t show up on the chart. Chart prices reflect the thinking and positioning of traders. When we saw an upward tendency in the Swiss franc, it was almost certainly due to short-covering in an oversold euro situation.

As for QE being a done deal on Thursday, don’t count your chickens, although this is not to say we won’t get most of what we have been led to expect. Failure to make the announcement, or talking about talking about it for March, would be a major mistake, and Mr. Draghi doesn’t do those. Still, Draghi probably has a couple of surprises up his sleeve. The problem for traders and forecasters is not the details of QE, like who will implement and how much it will be, but rather whether the move is not already fully built in to the euro and thus we have to worry about a “buy on the news” rally. And if everyone expects a buy on the news rally, why wouldn’t they buy now, ahead of time?
The other big event is Sunday’s Greek election, with The Economist pointing out that Mr. Tsipras, while not fully ready to govern, is rapidly becoming less of a firebrand. We no longer hear adolescent threats. Presumably a Grexit is irreversible and about three-quarters of Greek voters want to keep the euro. Tsipras may get more favorable repayment terms—a third bailout, in essence—but accidents can still happen. He is more likely to “fall back on socialist shibboleths than to tackle Greece’s pernicious clientelism and corruption.”

Finally, the Fed meets on Jan 27-28 and while the blackout on commentary starts today, we guess that we will start hearing more about the June First Rate Hike whatever the data, as St. Louis Fed Bullard proposed yesterday. The WSJ headline is “Fed Officials on Track to Raise Short-Term Rates Later in the Year.” This is not to say Mr. Hilsenrath (who has been saddled with a minder in recent years after going overboard) is the last word on the Fed, but he is well connected and it is the Wall Street Journal.

The question is whether the bond gang and a majority of big investors believe it, and if they push yields higher. The trajectory has been to the downside and we haven’t come close to the 3% we had fleetingly at end-2013. We can imagine a test of recent lows around 1.385%. But maybe Bullard just took the worst-case scenario off the table. With some 25% of European sovereign notes yielding zero or negative, how can the US return not look simply wonderful and the dollar fail to strengthen? The logic is impeccable. But we have had perverse outcomes before, so while we want to bet the ranch, don’t bet the ranch.