Seven Swiss Stars
The stars are aligned for the SNB to let EUR/CHF fall to parity. We count seven without Le Pen.
First, inflation is on track. The SNB expects headline inflation to ease gradually from 0.6% in February to 0.1% by year-end, but this is highly conservative. In our view, inflation could squeeze toward 1% in the near term, buoyed by accelerating Eurozone inflation (chart 1). Watch today’s CPI print closely.
Second, the US Treasury looms large, as it is due to release its latest report on the FX policies of US trading partners sometime this month. As argued elsewhere, Switzerland is already closest to meeting all three criteria of currency manipulation. Its current account surplus runs well above 3% of GDP, and the SNB has intervened well in excess of 2% over the past year. In the past, the Treasury acknowledged the constraints on domestic asset purchases given the limits of the Swiss bond market; but such subtleties could fall by the wayside under the Trump administration. Free trade with the US is too important for Switzerland to be risked by continued FX intervention (chart 2).
Third, the cantons can cope. Last year, the SNB could not incur an FX loss without jeopardizing dividends to the cantons, many of which had earmarked them. There is no such cost now. Under the new agreement with federal and cantonal governments, the SNB guarantees a dividend of 5bn francs over five years. Annual pay-outs are envisaged but can be deferred if necessary. This permits the SNB to incur a substantial valuation loss this year without jeopardizing cantonal budgets. Even with a hypothetical 10% loss on current assets of 745bn francs, a mere 0.2% yield over the next four years would suffice to earn the 5bn dividend, especially with 20bn carried over from 2016.
Fourth, the Swiss home bias is home-made. The private sector refuses to recycle current account surpluses through foreign direct or portfolio investment. The best explanation is that investors consider the FX risk too negatively skewed under a floor that lacks full credibility. Ironically, the outflows the SNB must have been hoping for may only materialize once the SNB allows the franc to settle into equilibrium first. Meanwhile, foreign safe-haven inflows are more likely to accelerate than to subside.
Fifth, the franc is no longer as overvalued as the SNB has claimed. The misalignment on PPP has halved over the past two years and is now under 10%. Even SNB staff economists recently noted the improvement. On external balance models the franc is even at fair value (chart 4), consistent with the robust export performance since 2015.
Sixth, the cost to the financial sector keeps rising with every week of heavy market intervention. Since most fresh liquidity goes into excess reserves charged at -75bs, the effective deposit rate has fallen to -30bps, and banks are likely to pass on more of this growing cost to customers if the SNB stays put.
Seventh, the trade is lightly owned by speculators. Risk reversals have returned to the post-Jan15 average from February lows, and net franc shorts on the IMM have doubled in recent weeks. On Corax, asset managers in particular have been selling the franc aggressively over the past year (chart 6).
Marketing communication : This document has not been developed in accordance with legal requirements designed to promote the independence of investment research and its author(s) is/are not subject to any prohibition on dealing in the relevant financial instrument ahead of the dissemination of the marketing communication.
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