The Swiss National Bank (SNB) today, in an unexpected move, took measures to address the recent strong appreciation of the Swiss franc. The 3-month libor target range was lowered to 0.00-0.25% from 0.00-0.75% and the SNB aims to keep the 3-month libor (currently 0.18%) as close to the zero-percent floor as possible.
In addition, the SNB will add liquidity to the financial system – aiming to expand banks’ sight deposits by CHF50bn. It intends to achieve this by purchasing outstanding SNB bills, by not renewing SNB bills that fall due and by no longer renewing repos.
These are the tools the SNB can use to try to stop the Swiss franc (which it sees as “massively overvalued”) from strengthening, while stopping short of intervention. The question is, will it work? We see a high risk that Swiss franc weakness will prove only temporary and that EUR/CHF will eventually move lower again (potentially even testing parity, if a negative risk scenario materializes), as great uncertainty remains about the European debt crisis and about the depth of the global economic slowdown. Hence, intervention risks have risen in Switzerland – though stepping up verbal intervention would likely be the first step.
We still see good value in short USD/CHF positions but recommend a well-defined stop/loss as a result of the higher tail-risk. Spikes in EUR/CHF should be considered as potential windows to reduce Swiss franc funding exposure.
The outlook for more Swiss franc liquidity in the system (the SNB aims to add CHF50bn) has also affected the money market and has seen the Swiss franc forward premium increase on the FX market (i.e. increasing the negative carry on the Swiss franc).
Ever since the global economy started to recover in 2009, the SNB has faced a tough policy dilemma. The strength of the domestic recovery began to warrant tighter monetary policy but, with strong global demand for the Swiss franc, this was achieved via a stronger currency, leaving the SNB in no position to raise rates.
The combination of zero percent interest rates and a stronger currency has left too easy monetary conditions on the domestic economy (increasing risks on, for example, the housing market) and too tight monetary conditions on the exporting sector (implying slower export growth). Since 2009 the Swiss franc has appreciated close to 40% against the euro. Until now the SNB has accepted this situation but as the Swiss franc appreciation has accelerated over recent months, the SNB has taken action. It appears the fear of financial instability and a return of deflation risks has risen at the SNB.
The probability of today’s action proving successful in stabilising EUR/CHF depends on the SNB’s credibility and market risk sentiment.
While additional liquidity should prove currency negative, we expect only a marginal impact. Swiss interest rates were already low and the interest rate spread was never the argument for investors to buy the Swiss franc. Rather, the high correlation between EUR/CHF and European sovereign spreads (see Chart 2) indicates that it is the European risk premium that has been driving the Swiss franc – with the franc being one of the preferred market instruments to hedge PIIGS risks. A small change in relative interest rates is not likely to affect these flows, in our view.
Instead, the Swiss franc outlook is likely to depend on how much the increased intervention risk has affected the market’s risk perception of EUR/CHF and on whether the European debt crisis escalates further. Intervention risks are clearly higher after the SNB announcement than before, which implies a higher tail-risk on EUR/CHF. However, interventions on the currency market are rarely successful and should risk sentiment deteriorate further, we would still expect to see strong Swiss franc demand. A negative market scenario (e.g. where Spanish and Italian spreads widen much further, the US is downgraded, global macro data does not improve, etc.) could even see EUR/CHF approach parity. This in turn, would be likely to trigger further SNB action with verbal intervention as the obvious first step – hence, volatility is likely stay high.
The option market is also still pricing in a higher probability of a Swiss franc appreciation compared with a depreciation – as reflected in only a modest rise in the 1-month EUR/CHF risk reversal from following today’s statement (see chart 3).
In addition, the SNB will add liquidity to the financial system – aiming to expand banks’ sight deposits by CHF50bn. It intends to achieve this by purchasing outstanding SNB bills, by not renewing SNB bills that fall due and by no longer renewing repos.
These are the tools the SNB can use to try to stop the Swiss franc (which it sees as “massively overvalued”) from strengthening, while stopping short of intervention. The question is, will it work? We see a high risk that Swiss franc weakness will prove only temporary and that EUR/CHF will eventually move lower again (potentially even testing parity, if a negative risk scenario materializes), as great uncertainty remains about the European debt crisis and about the depth of the global economic slowdown. Hence, intervention risks have risen in Switzerland – though stepping up verbal intervention would likely be the first step.
We still see good value in short USD/CHF positions but recommend a well-defined stop/loss as a result of the higher tail-risk. Spikes in EUR/CHF should be considered as potential windows to reduce Swiss franc funding exposure.
Swiss franc weakens and FX forwards turn more negative
The Swiss franc weakened immediately with EUR/CHF spiking from around 1.08 to above 1.10 – more than a 2% loss. The sell-off has stabilised for now, however, with EUR/CHF trading around the 1.11 level.The outlook for more Swiss franc liquidity in the system (the SNB aims to add CHF50bn) has also affected the money market and has seen the Swiss franc forward premium increase on the FX market (i.e. increasing the negative carry on the Swiss franc).
Why is the SNB taking these steps now?
Ever since the global economy started to recover in 2009, the SNB has faced a tough policy dilemma. The strength of the domestic recovery began to warrant tighter monetary policy but, with strong global demand for the Swiss franc, this was achieved via a stronger currency, leaving the SNB in no position to raise rates.
The combination of zero percent interest rates and a stronger currency has left too easy monetary conditions on the domestic economy (increasing risks on, for example, the housing market) and too tight monetary conditions on the exporting sector (implying slower export growth). Since 2009 the Swiss franc has appreciated close to 40% against the euro. Until now the SNB has accepted this situation but as the Swiss franc appreciation has accelerated over recent months, the SNB has taken action. It appears the fear of financial instability and a return of deflation risks has risen at the SNB.
SNB might have to take further steps
The probability of today’s action proving successful in stabilising EUR/CHF depends on the SNB’s credibility and market risk sentiment.
While additional liquidity should prove currency negative, we expect only a marginal impact. Swiss interest rates were already low and the interest rate spread was never the argument for investors to buy the Swiss franc. Rather, the high correlation between EUR/CHF and European sovereign spreads (see Chart 2) indicates that it is the European risk premium that has been driving the Swiss franc – with the franc being one of the preferred market instruments to hedge PIIGS risks. A small change in relative interest rates is not likely to affect these flows, in our view.
Instead, the Swiss franc outlook is likely to depend on how much the increased intervention risk has affected the market’s risk perception of EUR/CHF and on whether the European debt crisis escalates further. Intervention risks are clearly higher after the SNB announcement than before, which implies a higher tail-risk on EUR/CHF. However, interventions on the currency market are rarely successful and should risk sentiment deteriorate further, we would still expect to see strong Swiss franc demand. A negative market scenario (e.g. where Spanish and Italian spreads widen much further, the US is downgraded, global macro data does not improve, etc.) could even see EUR/CHF approach parity. This in turn, would be likely to trigger further SNB action with verbal intervention as the obvious first step – hence, volatility is likely stay high.
The option market is also still pricing in a higher probability of a Swiss franc appreciation compared with a depreciation – as reflected in only a modest rise in the 1-month EUR/CHF risk reversal from following today’s statement (see chart 3).
