SNB abandons euro peg ahead of expected ECB QE
The SNB has been under sustained fire in its attempt to defend its euro peg in recent years, as ECB loosening and risk aversion increased safe-haven flows. Thursday's rate cuts and the shift in the long-defended policy regime have shocked markets and have far-reaching implications for the euro and eastern Europe.
The Swiss National Bank abandoned its peg to the Swiss franc on Thursday, which set a euro floor of 1.20, and cut rates on sight deposit account balances by 0.5% to -0.75%, the lowest interest rate in history.
The surprise move, made outside of the normal meeting schedule, triggered widespread selling on both EURCHF and USDCHF currency pairs. EURCHF moved as low as 0.8500, having started the day at 1.20, while USDCHF was at one point trading at 0.7406, from 1.0188 at the start of trading.
The news also sent the euro briefly below $1.1600. “This move sees a major buyer of the euro leave the building and opens the way for further/faster EUR weakness,” says Société Générale, predicting it would lead to further dollar strengthening and increased risk aversion and FX volatility. The SNB's cap was introduced in September 2011 as an alternative to its previous attempt to resist inflation through buying foreign bonds as a form of quantitative easing.
“The SNB’s decision to abandon the floor and cut interest rates is surprising given inflation remains far below target, FX intervention had not been especially large lately and the stronger CHF introduces more downside risks to inflation projections,” says Daragh Maher, FX strategist at HSBC.
James Hughes, chief market analyst at Alpari, says: “It very much seems that around 1.05 for EURCHF and 0.90 for USDCHF are the levels that investors now feel is a better representation of the Swiss currency.”
Besides the currency revaluations, the move has had far-reaching implications. Traders have struggled to close positions and banks are struggling to offer prices due to the high volatility and demand, says Hughes, while Swiss and eastern European markets experienced heavy losses.
Switzerland's actions came in response to steadily increasing pressure in recent months. The collapse of the rouble and related tensions in Ukraine, along with weakening stock markets and concerns about weak global growth, have encouraged safe-haven flows into Switzerland, creating upward pressure on CHF.
And with the euro dragging CHF down against the dollar, the SNB decided to free its currency before the dramatic moves that an ECB announcement on QE would surely trigger, say analysts.
“Maybe the SNB knows something we don’t?” asks Paul Marson, chief investment officer of investment management boutique Monogram. “One explanation [for the SNB’s move] is the possibility of euro QE on a greater-than-anticipated scale. Perhaps the SNB decided not to fight the ECB and is unwilling to see a further substantial balance-sheet expansion and suffer the practical difficulties that coincide with the eventual unwinding of those positions.”
Jane Foley, senior currency strategist at Rabobank, says: “Although the move has shocked markets, there have been mutterings for some time that the SNB’s huge EUR holdings in its balance sheet could be making this policy more difficult to defend.”
In October, SNB vice-chairman of the board Jean-Pierre Danthine suggested that the SNB had no immediate plans to reduce the size of its balance sheet, which then included foreign currency reserves of around SFr462 billion, because it would create downside risks for the currency.
The reserves have climbed from SFr200 billion in mid-2011 to almost SFr500 billion now, notes SG, around 45% of which in euros. “These are now equivalent to 70% of Swiss GDP and have not been without controversy in Switzerland, as reflected in the referendum on the SNB's gold holdings on November 30, 2014,” the French bank says.
Simon Derrick, chief currency strategist at BNY Mellon, says: “The SNB clearly expected to see a huge surge of inflows in the week ahead and saw little reason to provide these buyers of CHF with an artificially cheap rate.”
Foley says: “The ECB is proving to be very successful in exporting its deflationary threat via the weaker EUR. It can also be argued that by whipping the markets up to a frenzy of anticipation about forthcoming QE, ECB president Mario Draghi’s main target could be to weaken the EUR further. For certain, the sharper the downward trend in the EUR, the harder the task of maintaining the EUR/CHF1.20 floor became.”
US private bank Brown Brothers Harriman suggests ECB QE may have felt that much closer today after the European Court of Justice's preliminary ruling yesterday removed a potential barrier to a European sovereign bond-buying programme. “The SNB likely anticipated, as do many market participants, for the euro to come under more pressure going forward,” says BBH.
Foley says: “The recent action taken by the ECB to weaken the EUR will only have created more difficulties for the SNB. IMF data have shown that in Q3 holdings of the EUR by reserve managers had already started to slip,” suggesting the ECB's rate cuts since June have discouraged traders from buying euros.
The SNB had already moved to combat this in December, imposing an interest rate of -0.25% on sight deposit account balances at the bank, and expanding the target range for three-month Libor to -0.75%/+0.25%.
This did not have the desired effect, with CHF remaining close to the ceiling. “It was therefore clear that something else would need to be done,” says Derrick. “What was not clear was quite what they would do and the timing of the move.”
Today, Thursday, saw the SNB upped the ante, lowering the interest paid on sight deposits to -0.75 basis points and moving its target range for three-month Libor to between -125bp and -25bp.
“There has been a clear attempt to soften the blow on the currency by cutting the interest rate,” says Hughes. “However, this seems to have only led to yet more volatility and moves on the CHF-based currency pairs.”
Despite negative interest rates, the strength of Switzerland’s budget and current account positions ensured strong demand for CHF – and are likely to continue to do so, says Foley.
“Even assuming that the SNB may have to intervene some more to help EURCHF stabilise, the deflationary risks facing Switzerland appear to have increased,” she says. “In an environment in which low interest rates are no longer proving an effective tool to counter deflation, the failure of the SNB’s floor should be lamented by policymakers who appear to be running out of policy tools.”
But SocGen suggests the SNB's move is not so much giving up as changing tack.
“After allowing the markets to clear, further intervention is likely – but possibly, in USDCHF rather than EURCHF, with added emphasis on the CHF trade-weighted index,” the bank says. “After all, the marginal buyer of Swiss luxury goods nowadays is more likely to be in Beijing or Shanghai than Frankfurt or Paris.”
Beyond that, it will likely wait to see where the market settles. “The SNB must hope that the EURCHF, after settling at a much lower level initially, then drifts back upwards towards 1.20. A more realistic hope might be that the USDCHF rate gets back above parity later this year,” says SG.
For an indication of what might happen, the SNB should look to recent history. The removal of the EURCHF peg “echoes how events played out in the late 1970s and early 1980s, given that the peg then lasted roughly the same length of time as the just-abandoned currency regime,” says Derrick. “We believe that the currency markets have returned to an environment that is surprisingly similar to that in force during the early part of the 1980s, and today's move provides yet another eerie reminder of that time.”
The impact for eastern Europe is also important: CHF-denominated mortgages in Poland now represent 40% of total mortgage loans in the country, according to ING, while Hungary is struggling with a current-account deficit.
Analysts at UBS are relatively sanguine, however, and suggest systemic leverage is far lower than a year ago, citing the conversion of mortgages in Hungary to local currency and corporate FX debt to EUR. Nevertheless, they recommend vigilance as EURHUF exchange rate rises. “While CHF leverage may now pose less systemic risks to Hungary, the same cannot be said for EUR leverage. FX debt of the public and corporate sectors (both almost entirely in EUR) accounts for c.30% and c.10%/GDP, respectively. As the EURHUF exchange rate rises, these sectors will likely come under increasing pressure to delever. As such, the danger is that EURHUF upside can feed on itself, by weighing on balance sheet, growth and capital inflows, and thus ultimately the currency.”
Nevertheless, bank stocks sold off in Hungary and Poland amid fears over unhedged FX exposures in the financial and corporate sector.