Earlier this month, Sweden’s Riksbank found itself in a rather awkward position.
Since doing an embarrassing about face in 2011 by reversing a rate hike cycle on the way to plunging headlong into NIRPdom, the Riksbank has watched Sweden’s housing bubble inflate to what certainly look like epic proportions. Household debt has also become concerning. Unfortunately, inflation expectations have generally been muted and because the Riksbank is in charge of managing inflation and not macroprudential policy, it’s inclined to maintain an easing bias even as it knows that tightening to rein in the housing bubble is probably prudent. Compounding the problem is the ECB, whose €1.1 trillion PSPP isn’t doing the Riksbank any favors when it comes to preventing the krona from strengthening. So you can imagine how vexed Riksbank Governor Stefan Ingves was going into the September 3 meeting knowing that just hours after he made his decision, some expected Mario Draghi to unveil an expansion of PSPP. Needless to say, if the Riksbank remained on hold and the ECB announced more QE, that would be bad news for the krona (i.e. it would strengthen) and thus for Sweden’s hopes of boosting inflation expectations.
Ultimately, the Riksbank gambled and remained on hold, and Mario Draghi only hinted at QE expansion rather than actually confirming it. Here’s what happened to the krona:
You can imagine how bad it would have been if the ECB had explicitly announced a PSPP expansion, committed to extending the program’s duration, or cut rates.
The reason that short story is important is that it highlights the precarious situation created by expectations that the ECB is set to meaningfully expand QE. A PSPP expansion or worse, further rate cuts, would imperil the efforts of regional, non-euro central banks who are struggling to keep a lid on currency appreciation and boost inflation. There is perhaps no better example of this dynamic than the EURCHF cross.
Indeed, following the fall of the peg in January - which might fairly be viewed as an attempt on the SNB’s part to get out ahead of ECB QE and avoid the massive intervention that would likely have been required to hold the floor in its wake - some now wonder what’s next in the event Eurozone 5yr/5yr inflation doesn’t pick up and the situation continues to deteriorate in China prompting the ECB to expand QE and/or take the depo rate further into negative territory.
For their part, Barclays suggests that in the event of a Mario Draghi rate cut, the SNB might well go to the “nuclear option” which would mean, in the final analysis, that retail deposits would no longer be spared from negative deposit rates.
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Our base case is for the ECB, at its October meeting, to extend its timebased commitment for QE for another six to nine months (ie’ through March or June 2017). As a second step, perhaps at the December meeting, the ECB could increase its pace of monthly purchases, or cut the deposit rate on reserves below the current -20bps. The latter option is less likely, but its probability is non-negligible and hence we consider the potential effects of all three courses of action here.
If, as is our base case, the ECB extends the time horizon over which it commits to European government bond purchases, we expect its primary impact to be on 2-3 year EONIA swap rates as the risk of a reversal of ECB balance sheet expansion policies is pushed further into the future. On the margin, the decline in medium-term EONIA rates likely will put further pressure on the EUR to depreciate. However, we do not expect that pressure to be too great on the EURCHF bilateral rate.
As a result, we would expect the SNB to adopt a ‘wait-and-see policy’ rather than respond with immediate action to an extension of the ECB’s time commitment to QE. If EURCHF began to reverse its trend of appreciation, the SNB might cut its deposit rate further into negative territory.
We would expect a similar ‘wait-and-see’ approach from the SNB in the case of an increased pace of purchases from the ECB. Because the policy is reversible if conditions improve – unlike an explicit time commitment – and the effects of QE appear to come mostly through the expectations channel, we would expect an acceleration of purchases to have even less impact on EURCHF than an extension of the ECB’s time commitment.
In contrast, a cut in the ECB’s deposit rate further into negative territory likely would have a significant impact on the EURCHF exchange rate and provoke a more immediate response from the SNB. Indeed, we expect that a cut in the ECB’s deposit rate may have a greater effect on EURCHF than on other EUR crosses. Switzerland applies its negative deposit rate to only a fraction of reserves, currently about 1/3rd of sight deposits by our calculation. In contrast, negative deposit rates apply to all reserves held at the ECB, Riksbank and Denmark’s Nationalbank. Consequently, a cut to the ECB’s deposit rate likely has a larger impact both on the economy and on the exchange rate than a proportionate cut by the SNB. An SNB response to an ECB deposit rate cut could take one of two forms: 1) a further cut in its deposit rate and CHF Libor target range; or 2) the ‘nuclear’ option, removing all exemptions from the negative deposit rate. We think the latter is more likely and would have major implications for EURCHF.
Most retail (private) depositors at domestic Swiss banks still do not face negative interest rates, but we would expect that to change if the SNB removed exemptions of domestic banks on sight deposits at the SNB. Domestic banks receive an exemption of 20x their November 2014 reserve requirement, an amount equal to about 75% of their respective sight deposits at the SNB. Because the non-exempt amount represents only about 5% of their total assets, Swiss banks have been able to swallow the costs and not pass negative rates on to most of their customers. As the non-exempt share has grown, banks gradually have extended negative rates to institutional clients, indirect clients (via external asset managers) and very large holdings of private clients. A removal of domestic banks’ exemption from negative deposit rates likely would force Swiss banks to pass on negative deposit rates as it would increase the proportion of assets charged negative rates to over 20%.
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Here's how Barclays sums up the above: "There is a low, but non-negligible risk that the ECB cuts its deposit rate further into negative territory at the December meeting, should the euro appreciate on a trade-weighted basis in the coming months, an action that we believe would initially lead to a significant decline in EURCHF but provoke the SNB to take decisive actions that may lead to rapid and sustained reversal of EURCHF."
There are a couple of interesting points here. First, we're beginning to see how competitive easing and the global currency wars beget not only an inevitable race to the botom, but in fact a race to the basement as the Riksbank, the ECB, and the SNB are forced to one up (or perhaps "one down" is the more appropriate term) each other or risk further imperiling their inflation targets. Note that this isn't exactly what the Paul Krugmans of the world would have you believe should be the outcome of ultra accommodative monetary policy.
Additionally, this points to the extent to which turmoil in EM (emanating, of course, from China in one way or another, whether it's the yuan deval or lackluster demand and the attendant global commodities slump) is set to feedback into advanced economies and DM monetary policy. That is, if we get an outright EM meltdown, Mario Draghi is more likely to ease, not only to stabilize markets, but also to ensure that Germany's export machine doesn't get hit even harder from China's hard landing. But as Draghi eases, so too must the Riksbank, and the SNB, lest the franc and krona should strengthen, putting inflation targets at risk. Here's what SNB chief Thomas Jordan had to say on Thursday after standing pat at today's meeting:
"Overall, the Swiss franc is still significantly overvalued, despite a slight depreciation. The negative interest rates in Switzerland and the SNB’s willingness to intervene as required in the foreign exchange market make investments in Swiss francs less attractive; both of these factors serve to ease the pressure on the franc. We must keep negative rates for the foreseeable future."
The SNB also slashed its inflation forecasts for this year and next.
In the end, we suppose the takeaway is this: in today's centrally planned world, the proliferation of NIRP means that nothing is sacred - not even a Swiss bank account.
Incidentally, as today's FOMC decision made clear, the next country to go NIRP might well be the US.