SNB Floor Turns Into A Trap Door

SNB Floor Turns Into A Trap Door

The Swiss National Bank today abandoned its 1.20 peg to the euro in a surprise move, combining it with a 50bps cut in interest rates (from a range of -1.25% to -0.25% compared to a previous range introduced just a week after their December quarterly policy meeting of -0.75% to +0.25%). The market reaction has been significant – EURCHF is clearly currently in a process of finding its feet following the decision, having fallen to about 0.85 immediately after the announcement but back up to about 1.00 as of writing

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The question now relates to where the CHF settles today– a 20% appreciation in the franc seems highly likely to do more damage to economic growth and inflation than the support that a 50bps cut in interest rates can provide.

Of course, it is worth remembering that with the euro having fallen significantly against the US dollar that the CHF had also depreciated against the dollar, but today’s decision takes us right back to the highest levels of CHF vs. USD we have seen since the end of 2011 – when the SNB introduced the euro peg. Moreover, Switzerland’s trade with Europe is far more important than its trade with the US (four times as much), so EURCHF is a much more important FX rate to focus on when it comes to the impact on the Swiss economy than USDCHF

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Economic Impact

It would seem likely that today’s decision will have significant ramifications in Switzerland as very few observers expected the floor to be dropped with some arguing that it looked set to remain in place for years.

Unless EURCHF was to recover back to levels much closer to the old 1.20 floor, the economy could be significantly impacted, as seems well reflected in the reaction of equity prices. At levels close to parity many businesses and investment decisions might not be seen as viable anymore and over time a significant volume of economic production could move outside the country.

If so, there could be a significant deflationary shock possibly not too dissimilar to the one Switzerland might have suffered had the floor not been introduced in 2011.

Credibility cost

Today’s decision has implications for central bank credibility and predictability more widely. Ever since September 2011, the SNB had been using the language of ‚utmost determination‛ to enforce the minimum exchange rate, and being, ‚prepared to buy foreign currency in unlimited quantities‛.

That such a stoic central bank could end up abandoning its long-held policy in such short shrift (this was of course not a scheduled meeting and comes after another unscheduled decision just a week following the December meeting) raises questions about how much markets might be able to trust central bank ‘commitments’ going forward. This is particularly important at a time where monetary policy guidance is the order of the day at many central banks. As we have learnt elsewhere (the UK, for example), it is important to take central bank indications about the timing of future policy moves with much caution.

Trading Implications

Two things matter most. First, what this means for SNB reserves. The removal of the floor clearly signals that they are less willing to accumulate reserves. But this is such a large policy mistake and the move in EURCHF lower so big, that ultimately they will (ARE) forced to return to the market to defend EURCHF at a lower level and at least stabilize the market.

Second, the position switching this causes from CHF funding to EUR funding. The market has VERY large positions in USDCHF part of which will now have to be converted into short EURUSD. This is clearly a negative for euro and likely to be reflected in EURCHF selling as well. These two factors would suggest overall the decision is a negative, as latter effect more important, euro becomes an even more important funding currency.

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The reaction in gold is relatively more muted thus far, with gold still trying to the digest the implications of the move, although XAUCHF is currently down by 11% on the back of the move in USDCHF. The transmission mechanism for gold would be through the impact of the SNB decision on the dollar.

The SNB statement acknowledges that the divergence in monetary policies is likely to continue, suggesting the potential for further dollar strength/euro weakness ahead, especially with the possible announcement of QE from the ECB. But the dollar index is little-changed thus far, while the knee-jerk reaction in EURUSD was only -1.5%, with the currency pair quickly rebounding from the lows. Gold is testing key trendline resistance currently.

Risk Appetitie Reaction

The negative impact on domestic risk appetite is one of the most important side-effects of this decision. First, the policy move marks a meaningful negative in terms of policy credibility: up until a few days ago the SNB had the “utmost determination” to defend a currency floor, which has now been fully reversed.

The SNB’s rationalization of the decision based on a strengthening USDCHF over the last few weeks hard to justify: the policy move has immediately led to a large tightening in Swiss financial conditions the CHF trade-weighted is at new record highs and the domestic stock market has dropped by more than 10%.

Ultimately then, the decision has effectively demonstrated a reduced willingness by the SNB to defend its inflation mandate, and the highly disruptive experience likely reduces the odds of other peripheral European central banks following suit in terms of currency floors (so marginally bullish their currencies).