Events in the eurozone – not the SNB – send Swiss franc lower
Speculation that the Swiss National Bank (SNB) is set to raise the floor in EURCHF has been cited as the catalyst for the sharp drop in the franc, but the trigger for the slide in the Swiss currency lies in the eurozone.
Talk that the SNB was preparing to lift the floor in EURCHF from SFr1.20 to SFr1.25 emerged on Tuesday as the currency pair posted its biggest one-day rally since the middle of March, surging a big figure from SFr1.21 to SFr1.22. Since then, weakness in the franc has persisted, with EURCHF standing above SFr1.23.
The SNB set the SFr1.20 floor in the Swiss franc in EURCHF in September 2011, in an attempt to protect its export sector from what it considered an excessive overvaluation of the franc. Since then its foreign exchange reserves have climbed to a record SFr438.8 billion as it has defended the floor, and account for more than 70% of Swiss GDP.
The central bank has admitted that managing those reserves is a challenge, so quite why market chatter emerged on Tuesday that the SNB was preparing to raise the floor – and therefore inevitably increase its FX reserve holdings and also attract international criticism – is unclear.
That is especially true as the market is doing the SNB’s work for them in weakening the franc.
It is more likely that the reversal of haven flows that sent the franc up to record highs in the first place is the driver of franc weakness.
That has been sparked by a marked reduction in peripheral eurozone sovereign debt risks in recent weeks, helped by the perceived reduction of political uncertainty in Italy and hopes that the liquidity provided by Japan’s massive quantitative easing (QE) plans will find its way into eurozone bond markets.
“Italian and Spanish funding costs reached their lowest level in three years, suggesting that the so-called carry trade in the eurozone periphery is in full swing yet again,” says Valentin Marinov, strategist at Citi.
“Hopes for quick resolution of the political impasse in Rome after the reappointment of president [Giorgio] Napolitano as well as expectations of more QE-fuelled demand for yield could lead to further reduction of bond risk premia in the near term.”
As the chart below shows, EURCHF has displayed relatively strong correlation with the spread between the yields of peripheral eurozone and German government bond yields. The current narrowing of bond spreads suggests, therefore, that EURCHF has room to move higher.
EURCHF supported by lower eurozone peripheral bond yield spreads to Germany
There is another dynamic emanating from the eurozone that also has the potential to weigh on the franc: the slowdown in growth in the region’s core. That has been reflected in this week’s German purchasing managers’ indices and Ifo business climate data, which were both worse than expected.
According to UBS, the Swiss franc is a shadow currency for Germany, with changes in German activity influencing activity in Switzerland, which sends a fifth of its exports to its northern neighbour. That can be seen in the chart below, which illustrates the close fit between German and Swiss purchasing managers’ indices.
|German, Swiss purchasing managers' indices|
Furthermore, notes Mansoor Mohi-uddin, head of FX strategy at UBS, Switzerland has similarly strong fiscal and trade positions as Germany.
“Thus the franc acts as a safe haven – just as the deutschemark did before the advent of the euro in 1999,” he says.
“This suggests the renewed weakness of the franc this week – at a time when the dataflow has showed the eurozone’s largest economy clearly slowing – may reflect concerns about Germany as much as unsubstantiated speculation about the SNB’s exchange rate regime.”
Indeed, it would appear there is no need for the SNB to act when events in the eurozone are conspiring to send the Swiss franc lower.