A shock from the Swiss Central Bank

25 January 2015
Knowledge Base

The Swiss National Bank recently scrapped its CHF/EUR currency peg in an unexpected move that roiled financial markets. Here, we explain what may have been behind the move and its implications. What did the Swiss National Bank do and what was the reaction in the financial markets ? The SNB abandoned the CHF’s exchange rate peg against the EUR, which had been set at EUR1.20 since September 2011. The CHF rallied sharply in response to the move, gaining as much as 40 per cent against the EUR at one point, and hitting its highest level against the USD in three years. Such volatility is extremely rare in G-10 currencies.

Swiss stocks lost some 10 per cent in local currency terms while Swiss bond yields fell further into negative territory. Swiss government bonds now offer negative yields right up to the 10-year segment of the curve. The currencies of countries with private sector liabilities denominated in the CHF – such as Poland and Hungary – also fell.

Why was the peg introduced in the first place?

The peg was introduced to prevent the currency rising to a point at which it would endanger the Swiss economy’s recovery. At the time in 2011, the CHF was trading close to parity with the EUR which, by our calculations, was almost four standard deviations above its fair value. The currency peg was also a response to the growing threat of deflation within Switzerland

Why did the SNB abandon it?

In explaining its decision, the SNB said it “was able to take advantage of this phase to adjust to the new situation”, arguing that the CHF was no longer excessively overvalued. Yet with Swiss inflation running at minus 0.3 per cent – well below the SNB’s target – there were clearly other factors behind the policy move. The SNB was obviously concerned that full-blown quantitative easing from the European Central Bank – likely to be announced at its January 22 meeting – would weaken the EUR further and threaten the CHF peg. This could have forced the central bank to print more money to keep the currency within its peg and consequently expand its balance sheet by far more than it was comfortable with.

Since 2011, its balance sheet has expanded by almost 250 per cent to CHF525 billion. It is worth noting that the SNB had been buying short-dated French and German government bonds since December, having acquired around CHF27.5 billion. In purchasing at that pace and at that maturity, it would soon have run out of bonds to buy: the prospect of shifting along the yield curve and credit spectrum may have been too unpalatable. Therefore, the SNB probably calculated that the cost and risk of maintaining a peg against the a EUR that would be in free-fall post-QE would be too great to bear.

What the SNB’s move means for:

a) The Swiss economy and Swiss companies
Recession is now likely. By our calculations, a 5 per cent rise in the CHF’s trade-weighted value is equivalent to a 100 basis point interest rate rise. Should the CHF hold at this higher level, we expect output in the export-dependent economy to contract by some 2 to 3 per cent this year and unemployment to climb by as much as 2 percentage points. Seen in this light, the SNB threatens to deliver a deflationary shock to the Swiss economy. Under a worst-case scenario, it is reasonable to expect to see some Swiss companies consider relocating their production facilities outside the country and others engage in a wholesale restructuring of their operations. In aggregate, companies in Switzerland’s SMI Index generate almost 90 per cent of their sales outside their home country. The SNB’s move to push deposit rates further into negative territory, meanwhile, is unlikely to mitigate the negative effects of CHF strength. Because the negative 0.75 per cent rate does not apply to the country’s biggest banks, lending is unlikely to grow, particularly at a time when demand for credit is weak. What is more, the policy could prompt deposit holders to shift their cash from small to large banks, which may increase systemic risks.

b) The outlook for monetary policy in the euro zone
The policy U-turn by the SNB suggests the ECB will implement full-blown quantitative easing at its January 22 meeting. We think the ECB is likely to buy sovereign debt in proportion to the size of the euro zone’s 18 economies – to keep the QE within its mandate and legal framework. That would mean roughly 18 per cent of any money spent would go on German bunds, 14 per cent on French bonds and 12 and 8 per cent on Italian and Spanish paper. We expect the programme to commit to bond purchases at a rate of EUR40 billion per month, up to at least EUR500 billion in total. Anything smaller than that would be a major disappointment to the market.

c) Emerging economies with a high proportion of CHF-denominatEmerging economies with a high proportion of CHF-denominated liabilities
The Hungarian forint and Polish zloty saw sharp falls in the wake of Thursday’s announcement. Both Hungary and Poland have high levels of private debt denominated in CHF; more than 40 per cent of Hungarian mortgages are CHF-based – equivalent to 9 per cent of Hungary’s GDP. In Poland, the volume of CHF mortgages is equivalent to 7.8 per cent of GDP. A higher CHF would clearly make it increasingly difficult for households to service those debts. (In Hungary’s case, however, borrowers may benefit from a government programme aimed at converting mortgages into local currency).

d) The credibility of central bank policy guidance
The SNB’s credibility has arguably suffered following its policy move, not least because it had vowed to defend the currency peg at all costs only days earlier. But more importantly, with deflation becoming entrenched and the CHF now back at the levels that prevailed in 2011 – our models indicate that it is trading about 17 per cent above its fair value on a trade-weighted basis – it is difficult to find an economic justification for the central bank’s move.
The fact that it did not consider other options – such as a CHF peg against a basket of currencies – is an additional concern.
More broadly, the SNB’s move epitomises the difficulties central banks face in the management of the unconventional policies they have established since the beginning of the 2008 debt crisis. Investors – not to mention Swiss companies – were caught off-guard by a central bank that had established a reputation for reliability. Investors may be warier of central banks’ forward guidance in future.

e) Equity and bond markets
– The SNB’s move will probably make investors more sceptical about central banks’ interest rate guidance in future, which in turn could lead to increased volatility across financial markets; gold may be a beneficiary.
– The scrapping of the peg is unequivocally negative for Swiss stocks, which were arguably already trading at an expensive level of over 16 times 2015 earnings.
– To the extent that the policy U-turn hints at full-blown QE from the ECB, euro zone asset markets should gain.
– The JPY could strengthen if investors choose to test the Bank of Japan’s resolve to end deflation. Other central banks operating currency pegs – such as the Danish central bank, which pegs the DKK to the EUR – may also find their policies put to the test by the markets.
– French and German government bonds may suffer some selling pressure given that the SNB has been purchasing such debt in high volumes since December although potential QE from the ECB may offset this.

Source: Pictet

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