Bond Outlook by bridport & cie, April 11 2012
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Bond Outlook by bridport & cie, April 11 2012

Is the SNB’s policy stance sustainable in the medium term?

As a small country relying heavily on the euro area, the Swiss economy has declined sharply during the last year. There have however been recent signs of recovery with a KOF leading indicator improving, manufacturing contracting at a weaker pace than expected and investor confidence increasing for a third month in March. Exports also climbed, adding to signs the economy is stabilizing. The government doesn’t see a threat of recession as exports should be helped by the franc’s floor at 1.20 against the Euro, and as consumer demand remains elevated. However, geo-political uncertainty persists and could have a considerable effect on prices and growth stability if risks materialize. This positive outlook is shared by the Swiss National Bank (SNB) which also raised its forecast for growth this year to about 1.0% from 0.5%.


In addition to the international uncertainty, there is another key issue weighing on the Swiss economy. The franc, which is considered a haven in times of turmoil, has benefited massively from risk aversion during the debt crisis, resulting in massive inflows of capital – and this continues with fears returning about Spain. The franc appreciated as much as 37% against the euro in the 12 months before the floor at 1.20 was introduced on September 6th. Loose monetary conditions stimulate domestic demand, but they also put upward pressure on asset prices due to money and credit growth well above long-term averages. As a result, property price inflation accelerated over the past 2 years. The SNB and the IMF clearly state that the Swiss mortgage and real estate market for residential property shows growing signs of imbalances, and these could lead to considerable risks to financial stability.


Currently, even after the introduction of the floor, the Swiss currency is still about 8% stronger against the euro than it was a year ago, and deflation still threatens the economy. In this context, the SNB maintains its accommodative bias. The bank confirms that it stands ready to take further measures at any time if the economic outlook and the risk of deflation so require.


In terms of policy going forward, we do not expect a considerable shift in the central bank's policy stance. They will keep their policy rate target on hold over the forecast horizon, to prevent a further appreciation of the exchange rate. They should also maintain their exchange rate ceiling for the time being as the franc appreciates slightly when tensions in the euro area increase further. In the meantime, housing imbalances could be circumvented without the use of conventional monetary policy tools, i.e. interest rates, by implementing prudential macro policy, or fiscal tightening.


As a consequence, many investors wonder whether the cost of this monetary policy is sustainable in the medium term. For the first three months, the EUR-CHF traded relatively far from the floor level. We detected a change of credibility due to the Hildebrand’s resignation in December, and since then, the margin has declined. We would suggest that during the first six months of the peg, the central bank didn’t need much money to defend the floor, as the SNB’s assertions proven credible. Last Thursday however, the EUR-CHF broke the floor for a minute, before SNB intervention brought it quickly back above the 1.20 ceiling, confirming that the bank is ready to fight any further attacks.


Looking at the SNB’s income statement, we can conclude that the current cost of the floor is sustainable in the medium term as the bank ‘curiously’ published a profit of CHF 13.5 billion in 2011 compared with a loss of 19.2 billion the previous year. On the floor operation itself, the SNB spent CHF 17.8 billion in 2011 to stem what it called the currency’s “massive overvaluation.” That compares with CHF 144 billion it used in the previous year to buy currencies, a policy that sparked a record loss. Franc positions had a net loss of CHF 163 million in 2011, partly because of liquidity-absorbing repo operations. Currently, the Swiss National Bank’s foreign currency reserves stood at CHF 237.5 billion, up from CHF 227.2 billion in February.


Macro Focus

US: the positive momentum continues: retails sales rose 4.3% YoY; the Bloomberg Consumer Comfort Index climbed to the highest level in four years; apartment vacancies fell to their lowest level since 2001. The ISM non-manufacturing index dropped but remains largely above the key level of 50. Only employment data have divided analysts. Fewer jobs than forecast were added in March (120,000 the fewest in five months). While companies expanded payrolls, local-government payrolls fell to the lowest level in more than six years. On the other side, claims for unemployment benefits continue to drop.


Fed: the improving economy reduces the need for new stimulus, even as policy makers stick to a plan to hold the benchmark interest rate near zero at least through late 2014. Fed officials called for additional stimulus only “if the economy lost momentum” or if inflation stays below their 2% inflation target.


Euro area data are still disappointing. German industrial output fell more than economists forecast as cold weather kept workers off construction sites. Production decreased 1.3% from January. Retail sales declined in February, led by Germany, as rising oil prices and government budget cuts prompted consumers to pare spending.


Spain has been the main driver this week as the country struggled to borrow in financial markets. It is the only country in the world that hasn’t benefited from the credit rally fuelled by central bank cash as investors bet its government will be the fourth in the euro region to request a rescue.


ECB: President Mario Draghi said policy makers are prepared to act against inflation threats if needed, while assuring investors that the ECB doesn’t plan to withdraw emergency stimulus any time soon. In the meantime, the Bundesbank and Austrian Central Bank are the first central banks in the euro zone to use a new privilege by saying they will not accept bank bonds supported by member states receiving aid from the European Union and the International Monetary Fund (Greece, Portugal and Ireland) as collateral.


BOE: the Bank of England left its benchmark interest rate at a record low of 0.5% and voted to complete their current monetary-stimulus program at GBP 325 billion as they get ready to debate next month whether to bring the program to a halt.


UK: The central bank's decisions come amid mixed signals for the economy. Job vacancies in London’s financial services companies fell 8% in March as an uncertain U.K. economy discourages hiring. Manufacturing output unexpectedly declined for a second month, while services growth unexpectedly accelerated to 55.3 from 53.8 in February. House prices rose the most in almost three years, boosted by demand from first-time buyers before the expiry of a tax holiday on some home purchases. According to the National Institute of Economic and Social Research’s estimate, Gross domestic product rose 0.1% in the first quarter.


SZ: consumer prices dropped (-1.0% YoY) for a sixth straight month in March as the franc’s gains lowered costs of imported goods.


SNB: The Bank’s supervisory board will discuss the selection of a successor to former president Philipp Hildebrand on April 13. The Bank Council will consider candidates and then propose one to the Swiss government, a process which means that the position probably won’t be filled as soon as next week.


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