It’s unlikely that the SNB floor in EURCHF will give way in the near term but changing dynamics in 2015 will lower the SNB commitment to the rigid policy. Our forecasted depreciation in the EURUSD combined with the use of negative interest rates should provide the SNB with a welcomed opportunity to discretely step away from the EURCHF floor.
In the near term the SNB will emphatically defend the current policy, given the ECB policy, SNB credibility issues, Swiss deflation fears and CHF overvaluation. The EURCHF floor has been constructed on the bank’s credibility and ability to freely expand its balances though physical intervention. The absolute rejection of the “Save Our Swiss Gold” initiative was a strong message to the markets. The referendum would have changed Switzerland constitution to enforce an irreversible increase in the SNB gold reserves to 20% of the bank’s balance sheet, and thereby limited the central bank’s ability to conduct policy strategy. In essence, the vote became a referendum on the SNB current policy and credibility. Yet when the smoke cleared, 77.3% of the voters voted against the measure, which signaled the SNB had a clear mandate from Swiss citizens. As recognition of the SNB credibility and their unwavering support for policy strategy, speculators reloaded on long EURCHF with the expectations that the downside is limited. Looking ahead, our outlook for EUR weakness will be a key rationale for a change in the SNB minimum exchange rate policy. Growth in the Eurozone lingers below 1%, unemployment is well above 10% and inflation has slowed to 0.3%, below the ECB target of 2%. In the Eurozone, the inflation trend is dangerously close to outright deflation. As a consequence, the ECB President Draghi has pledged to use unconventional monetary policy and enlarge the ECB balance sheet to 2012 levels, implying the purchase of €1trn assets. The ECB has already started to increase funding, buying covered bonds and ABS, yet the expansion is well below target. We would therefore conclude that it is highly likely that the ECB will include buying European sovereign bonds within their strategy. Our view is for the ECB to announce full-blown QE in January or latest March 2015 and trigger further EUR devaluation.
The consequence of the ECB action is two-fold. First the large capital outflows into Switzerland will highlight the credibility issue at stake. The newly minted mandate gives the SNB pledge to enforce the floor by buying foreign currency in unlimited quantities real teeth. Yet balance sheet expansion has limits and the SNB now knows that. The SNB is unlikely to desire to protect the floor indefinitely. Secondly, because of the EURCHF floor and our FX forecasts, CHF on a trade weight base should depreciate closer to its long-term average. In addition, this trade-weighted depreciation should provide further stimulus to a Swiss economy that has so far handled the downturn of its large trading partner extremely well. With domestic and global monetary policy ultra-loose and less noticeable overvaluation the SNB will reconsider the inevitability of the floor.
What the SNB needs is a bit of room, between the minimum exchange rate and EURCHF market price, to avoid a disorderly decline. SNB still has a powerful tool in the form of negative deposit rates which in the short term can relieve some pressure. The SNB will be forced to use this unconventional policy to offset the flow driven by the ECB initiation of full-blown QE. The immediate result will be broad based selling of CHF, sending EURCHF higher. This move will provide the opportunity for the SNB to quietly step away from the floor without any disruptive results, as in the longer term the Euro, suffering from QE induced weakness, will eventually send the EURCHF below 1.20.