UBS warns on euro-swiss franc floor
The Swiss National Bank (SNB) could be in for a challenging end to the year as the pressure on the floor in EURCHF intensifies, warns UBS.
UBS says a trend is starting to build up in EURCHF, with its clients being net sellers of EURCHF for three consecutive weeks.
That has come as worries about the eurozone sovereign debt crisis have resurfaced, boosting haven demand for the CHF.
UBS says hedge funds have been the heaviest sellers of EURCHF. The bank doubts, given their previous experience, whether this client group will mount a concerted attempt to break through the floor.
“However, this is currently an environment where any trend – no matter how small – tends to be jumped upon,” warns Geoffrey Yu, strategist at UBS.
“The SNB may need to be braced for a more challenging end to the year, as opposed to the quiet autumn it has enjoyed so far.”
The SNB has reiterated its intention to defend the SFr1.20 floor with whatever means necessary.
Last week, Fritz Zürbrugg, a new member of the SNB’s governing board, used a speech in Geneva to remind the market that the central bank is convinced of the effectiveness of it currency policy and would continue to pursue it “with the utmost determination”.
Zürbrugg conceded, however, that managing SNB’s growing FX reserves – they now stand at nearly 70% of Swiss GDP – was already a substantial challenge.
“In Switzerland, the SNB has seen its foreign exchange reserves grow substantially,” he says. “Managing these reserves is currently a major challenge, and has become the subject of much scrutiny by both the media and SNB watchers.”
The SNB has had to manage the allocation of currencies in its FX reserves, and that has meant the central bank diversifying away from the EUR holdings that it accumulates as a consequence of its intervention policy.
Zürbrugg explains that the SNB cannot hedge against exchange-rate risk without neutralizing the impact of monetary policy, given that each hedging operation is, in effect, a purchase of CHF against other currencies.
“Thus the main tool in managing exchange-rate risk is the most optimal diversification possible,” says Zürbrugg. “Faced with the strong growth in foreign exchange reserves, the need for diversification has therefore taken on even greater significance.”
The SNB holds its reserves in EUR, USD, JPY, GBP and CAD. Since 2010, it has also invested in what it terms minor currencies, adding AUD, SGD, SEK, DKK and KRW to its list of investment currencies.
“The SNB is constantly assessing ways to improve the diversification of its investments,” says Zürbrugg. “I would like to stress that we actively analyze and monitor new asset classes and different currencies in both advanced and developing economies, to reduce risk concentration over time.”
In the second quarter, the SNB’s reserves accelerated as the eurozone debt crisis escalated.
That reserve growth was tempered in the third quarter as the European Central Bank (ECB) introduced its bond-buying scheme and Mario Draghi, ECB president, pledged to do whatever it takes to preserve the EUR.
Still, the effect of the SNB’s reserve diversification did not disappear from the FX market in the third quarter.
As Zürbrugg explains, the SNB is required to invest its portfolio without destabilizing markets, and therefore places amounts it believes can be easily absorbed.
“This implies that any diversification after a large inflow of foreign exchange reserves must be gradual,” he says.
In other words, the third quarter saw pressure on EUR crosses as the SNB rebalanced the overhang of the reserves it received in the second quarter.
So far this quarter, the SNB has not had to intervene – reserves fell for the first time in six months in October – and now its reserves are broadly balanced, it has not added to the selling pressure on other EUR crosses.
That could change if there is another attempt by hedge funds to break the SFr1.20 floor. The SNB’s defence of the level could add to the selling pressure on EUR crosses for months to come.