Following the recent fall of the Swiss franc against the euro, there were paradoxical comments on the opportunity on both moving the Swiss National Bank’s floor lower (say to 1.25 for example) or on abandoning it altogether (or moving it higher). We believe both options are very unlikely, at least in the coming months. Moving the floor lower would be a bad idea in our view. As we have seen, the extent of the franc’s overvaluation is quite debatable and the lower the floor, the quicker a monetary policy [9] dilemma may emerge. Moreover, in the event renewed upward pressures on the franc occur once again, a lower floor may prove more costly in terms of FX interventions. In any case, the SNB was relatively clear recently in saying that it has no plan to move the floor.
On the other hand, now that the euro is far higher than 1.20 francs, it could look tempting for the SNB to take the opportunity to simply abandon the floor. However, this would be quite a risky bet. As mentioned below, a new bout of the euro crisis may break out at some stage or another over the coming months, propelling the franc sharply higher once again. Then what would the SNB do? Reset a floor? In short, by abandoning the floor already now, the SNB would be playing dangerously with its credibility. In our view, we continue to believe the floor might be abandoned (or possibly raised substantially) at some stage, but most likely not before next year.
The franc has weakened sharply against the euro this year
Over the past week or so, the Swiss franc suddenly weakened significantly against the single currency, reaching almost CHF1.255 per euro, its lowest level since May 2011. Behind the scene, this sudden decline was linked to a further substantial reduction in the systemic risk associated with the euro crisis and the widespread practice of charging penalty rates on CHF deposits. However, the short-term trigger of the CHF fall was clearly last week’s surprisingly “not-so-dovish” ECB press conference.
[10]
What to expect for the future?
The first thing to keep in mind is that the stability that prevailed on the EUR/CHF during most of last year lies in the fact that the SNB had to sell huge amounts of francs. According to our rough estimates, between mid-May and mid-September 2012, SNB FX interventions reached a massive CHF190bn. A good part of the money invested in the franc during that period was probably “hot money” seeking protection from a potential euro breakup. This means that potentially substantial amounts may leave the franc if the euro area systemic risk is reduced further. Moreover, short-covering probably played a significant role in the franc’s recent downward move and this may continue, at least in the short run. The consequence is that it is extremely difficult to figure out up to what point the recent appreciation of the euro against the franc will go in the short run, but we believe the move may well extend further for a while.
Swiss franc weakness unlikely to last in our view
Nevertheless, we do not believe the franc’s recent depreciation against the euro will prove a lasting phenomenon. It is far from sure that risk aversion will continue to fall over the coming few months. Peripheral European countries are in a deep recession and even German economic activity contracted in Q4 2012. Austerity programmes are a powerful drag on growth and public budget rebalancing is far from being achieved. At some stage over the coming few months, a new bout of the euro crisis may burst. And, even if it does not, the prolonged weakness of the euro area economy may well lead to more accommodative measures by the ECB. Moreover, a temporary surge in risk aversion is also possible around the looming US political challenges (the debt ceiling, the ‘Sequester’ and the continuing budget resolution).
[11]
From a longer-term point of view, things are also not that straightforward either. At first sight, it would seem reasonable to bet on a lower Swiss franc against the euro. First, although some downward euro correction is quite possible in the short run, we expect the single currency to appreciate further against the dollar during the course of 2013, on the back of improving world and European growth and further – although irregular – progress in resolving the euro crisis. Second, the Swiss franc still seems to be overvalued (see chart above).
[12]
However, we are not convinced by these lines of reasoning. The extent of the franc’s overvaluation is debatable. Swiss exports were surprisingly resilient to the strength of the franc. The Swiss export industry is currently not suffering so much from a lack of competitiveness but rather from a lack of demand.
Moreover, it’s worth noting that at current inflation differentials (around 2.5 percentage points less inflation in Switzerland compared to the weighted average of its trading partners), the estimated overvaluation of the real trade weighted value of the Swiss franc (around 2.5% currently) would be erased in a year or so, and all that with no further nominal exchange rate movements.
Toward a monetary policy [9] dilemma at the SNB?
An even more important point playing to the advantage of the Swiss franc is the potential gradual building of a SNB “monetary policy [9] dilemma” later this year. Already currently, the Swiss economy is not that weak. Employment is booming and the pace of house price increases remains quite elevated. In that context, the more world and European growth improves over the coming months, the more Swiss growth will accelerate, and growth prospects will brighten. This means that the same factors behind our rather bullish scenario for the euro against the dollar may well lead, later in 2013, to anticipations that a SNB ‘exit strategy’ is getting closer, which is likely to give some support to the Swiss franc.
Consequently, we believe by year-end the Swiss franc is more likely to be stronger than today, rather than weaker. We maintain our forecast of a euro at 1.20-1.22 franc in 12 months’ time.
[13]
The floor should remain in place and unchanged
Following the recent fall of the Swiss franc against the euro, there were paradoxical comments on the opportunity on both moving the floor lower (say to 1.25 for example) or on abandoning it altogether (or moving it higher). We believe both options are very unlikely, at least in the coming months. Moving the floor lower would be a bad idea in our view. As we have seen, the extent of the franc’s overvaluation is quite debatable and the lower the floor, the quicker a monetary policy [9] dilemma may emerge. Moreover, in the event renewed upward pressures on the franc occur once again, a lower floor may prove more costly in terms of FX interventions. In any case, the SNB was relatively clear recently in saying that it has no plan to move the floor.
On the other hand, now that the euro is far higher than 1.20 francs, it could look tempting for the SNB to take the opportunity to simply abandon the floor. However, this would be quite a risky bet. As mentioned above, a new bout of the euro crisis may break out at some stage or another over the coming months, propelling the franc sharply higher once again. Then what would the SNB do? Reset a floor? In short, by abandoning the floor already now, the SNB would be playing dangerously with its credibility. In our view, we continue to believe the floor might be abandoned (or possibly raised substantially) at some stage, but most likely not before next year.
Critically, as SNBCHF blog noted [14], while the SNB did make aprofit last year, Q4 saw them give a lot of it back - suggesting the deltas (or exposure) is very high (and senstivie to JPY and Gold):
The profit in foreign currency positions fell from 10.3 billion in the first three quarters to 4.7 billion in the whole year implying a loss of 5.6 billion in the last quarter. The loss was 4 billion higher than our estimate (possible reason: the IMF FX reserves data used for our estimate will be revised downwards). Especially the yen and gold depreciated in the last quarter. The latest monetary data showed that the SNB reduced sight deposits and liabilities by only 4 billion francs in Q4/2012 and they even increased by one billion francs last week.