January 15th, 2015 3:31 pm
This is very long but worthwhile and informative.
Via TDSecurities:
The SNB Aftermath
· The SNB’s surprise decision to drop the floor opens up markets to new dynamics going forward.
· EUR depreciation can be particularly sped up from here, with our initial target between this and ECB QE of 1.12 in EURUSD and we will re-examine that level more formally over the coming week. It can also take some pressure off JPY appreciation in times of market stress as CHF can once again join the ranks of the safe havens—albeit one with a significantly negative interest rate as well as the persistent threat of SNB intervention.
· Trying to maintain the CHF floor in the context of significant and lengthy ECB sovereign bond buying would likely have been like trying to fit a square peg in a round hole, and with negative policy rates now more normal, that proves to be a more acceptable tool.
· This also opens up scope for a further round of a war of rate setting across Europe from the ECB, Norges Bank, Riksbank, and the SNB as well, with the latter adding likely further FX intervention into the mix.
· Ultimately, this decision could be seen as an SNB vote of confidence for both the sustainability of the strong USD trend and ultimate start of a Fed hiking cycle as well as the vote of confidence for the cross-border flow we will see in EUR post-QE.
As the dust settles and SNB President Jordan has finished his press conference, there are still numerous questions as to why now and what lasting impact will we see in markets?
Risk On or Risk Off?
The typical reaction for markets is that CHF positive is risk negative, and knee-jerk reaction in the markets to sell equities and buy bonds on the announcement of the SNB dropping the floor was consistent with that programming. However, across FX, the 1.25% move lower in USDJPY was certainly obeying the rules of that game but with the dollar bloc recovering their initial losses and posting gains on the day vis-à-vis the USD, it suggests different dynamics at work here. So we would push back against those suggesting this is a risk off catalyst, even if some of the moves on the day necessarily fold into that dynamic. The Swiss franc does not drive the risk environment, it reacts to it.
There is a question now of whether CHF is even able to return to its old role as safe haven currency in times of risk aversion, as it’s going to be more of a gamble than it has been in the past. Not only is there the disincentive of substantially negative interest rates, but there’s also the constant threat that the SNB could come in to intervene in FX markets again, as there is not a lot of clarity on where SNB wants to see CHF settle from here, and what exactly would trigger intervention. At current levels, which is also where the SNB was intervening earlier this morning, buying CHF in times of risk aversion looks like a risky proposition.
Our USDCHF market fair value model would suggest 1.21 (with relative market moves on the day having shifted that lower from 1.23 on the day) should be the appropriate anchor, PPPs would put fair value a bit lower in the 1.00-1.15 range, and so even though we have moved to around 0.90 on the day, if the global risk environment were to remain the same, we would expect to see some further retracement higher over the next 3-6 months.
For EURCHF, it’s difficult to tell when it might return north of 1.20 again without SNB involvement. The most recent G10 example of a currency floor breaking was probably during the UK’s ERM crisis in September 1992, although admittedly that was a very different case with the BoE then unable to prevent GBP depreciation, while in the current case the SNB pulled the plug on trying to fight CHF appreciation. In the UK’s case it’s worth noting that GBPDEM didn’t return to its 1992 levels until 1997, so nearly 5 years later. The EURCHF case may not be too dissimilar with EUR likely to continue to depreciate through the next two years of ECB balance sheet expansion, preventing any substantial move higher in EURCHF.
Why Now?
Jordan’s press conference offered no convincing answer on this front. His public answer was that the franc grew less overvalued since the floor was introduced in September 2011. That is certainly true on USDCHF, where we had recently moved back above parity for the first time since 2010, though only to drop below 90 cents on the announcement. But for EURCHF, it was only because of intervention that we had remained where we where and on the day, are back to the 2011 lows. With the ECB likely to introduce sovereign QE next week, EUR depreciation is likely to continue, which means EURCHF is likely to remain under further pressure to depreciate. And it is the EUR moves that will dominate the impact on pass-through into Swiss inflation and GDP so expectations for both must now be lowered further, with lower oil prices exacerbating the former and somewhat offsetting the latter.
It is possible there were concerns of maintaining the floor in the context of negative rates. It is more likely that while in 2011, negative policy rates seems further down the spectrum of the absurd, today they are just another normal policy tool and financial systems have shown that banks and markets can handle this so the SNB wanted to return to more normal, exceptional monetary policies. But the most likely reason in our opinion was the potentially costly implication for the SNB to remain bid euros in the midst of what we expect will be a €500bn, two-year government bond buying program by the ECB. As the SNB has been intervening to weaken their currency, they could have continued to print francs to make these purchases, but this would have implied a likely significant acceleration in the growth of their balance sheet.
By shifting the policy focus to negative interest rates, it can prove less directly costly if they feel the economy is ready to digest the adjustment. A sustained 10% appreciation of the currency would typically see real exports fall around 1% while real imports rise by 3%. Some of this would typically be offset the 50bps cut in the policy rate, which if we factor in the 25bps cut already taking effect this month would have implied a boost to GDP of 1.5-2.5pp over the next 12-18m. However given the negative rate on sight deposits is not widespread on smaller domestic savers, this pass-through would be less. So the calculus here is difficult to say definitively, but it is more advantageous than the situation in 2011 to let the market determine the level of the currency.
Lastly, we would mention that there have been suggestions that this could be a temporary stress reliever by the SNB, and that they could return to the market in short order and re-introduce a floor at a lower level on the assumption that this was needed given ECB QE is largely priced in. Had this been the intention, they simply could have lowered the floor, rather than go through a charade of dropping it only to bring it back, but any concern there in the market could limit some immediate drift lower.
Another Decelerant to Euro Depreciation Falls by the Wayside
By taking the SNB off of the required bid for euros, this provides an ability for EURUSD’s move lower to accelerate on the back of QE—already itself accelerated by likely being the first central bank to introduce QE in the context of negative rates. One natural buyer is now out of the market, and could actually take the opportunity to eventually sell some EUR holdings back to the ECB with the latter taking over as primary European buyer. Although we don’t expect the SNB to begin shrinking its balance sheet anytime soon, given that it would merely exacerbate CHF appreciation after the outsized move that we already saw today. We had been looking for EURUSD to target around 1.18 on the assumption that the risk of the ECB shifting to outright sovereign bond buying remained close to 50/50 as of last November. With it a done deal, this extends the downside to at least 1.12, and we will re-examine this forecast next week.
War of Negative Rates to Intensify
The SNB has now set the new low bar for a negative policy rate at -75bps. There is nothing to stop them from taking this further, nor extending it more broadly across domestic savers. But the ECB’s –20bps deposit rate, the Riksbank’s 0% repo rate, and certainly the Norges Bank’s rich yield feast of 1.25% all start to look like potential avenues to ease further. This is the driver for the broad-based underperformance of all the European crosses, DKK included, on the day. Rate cuts are back in vogue and the zero lower bound is much less binding.
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