Currencies: CHF: SNB – the Only One in Control?

SNB monetary strategy helped ride the storm

While European and US markets risk premiums (as measured by 3M Libor over the Official Target Rate) are still hovering between 60 and 90bp, the SNB has managed to achieve a zero premium in the Swiss money market: Libor now matches the middle of the target set by the SNB. In response to the surge in Libor in early August (about 10bp), the SNB immediately lowered the 1-week repo rate from 2.43% to 2.29%, and below 2.1% more recently.

Contrary to most other G10 central banks, the SNB decided in 1999 not to target a policy rate. Instead, it opted to use the 3-month Libor market rate as its policy objective. The main reasons were twofold:

(i) The SNB did not want a rigid operational objective and preferred a rate able to fluctuate in response to market tensions and absorb temporary shocks. Moreover, the importance of the exchange rate fluctuations for the Swiss economy required a policy framework flexible enough so that any eventual FX tensions would not dictate changes to or be interpreted as a change in policy orientation.

(ii) The Libor defines a monetary policy that is reflective of true credit market conditions and limits the risks of divergence between the official rate and the market rate.

The effectiveness of monetary policy itself is closely linked to the operational objective of a central bank. In fact, what we have witnessed since August is reminiscent of the fact that actual credit market conditions (as reflected by interbank lending conditions) may not be dictated by the official rate, and that their disconnect reflects a lowering of the effective control central banks may have on market credit conditions (point (i) above).

But will this be enough?

Renewed global funding pressures still challenge the SNB, and with the global growth outlook becoming more uncertain, next week’s policy decision is a close call.

The overall importance of the financial sector for the Swiss economy (15% of GDP, 6% of total workforce), and the possibility of abrupt swings in the CHF, especially in EUR/CHF, are clearly sources of risk for the SNB (see below on the latter risk). But we do think that risks are limited on both fronts.

While we do believe that there are only minimal chances that the SNB cuts rates (this would be related to a sudden and abrupt worsening of funding pressures in Switzerland), the choice between remaining on hold and implementing a rate hike is not trivial, and will probably be a source of intense internal debate.

We still believe that the SNB will raise next week

First, fundamentals are still strong. Growth in 3Q has surprised on the upside (2.9%Y), as did inflation in November (up 1.8%Y). The actual data will likely ‘overshoot’ the September SNB forecasts for the year-end (in terms of both inflation and growth). Considering energy/food price developments, and the AXJ region likely turning into an inflationary force, risks on inflation are definitely tilted to the upside going into next year, in our view.

Second, we think that the exchange rate is still undervalued (this is especially true against the EUR, for which we calculated a close to 20% undervaluation), and it provides a welcome buffer to any moderate global slowing activity.

Third, and related to the second point, the pass-through from past exchange rate weakness is increasingly feeding through imported prices (in November, imported prices accelerated to 3.6%Y from 1.8%Y the previous month).

Third, as discussed above, a stable and normalised money market is important for any central bank in conducting monetary policy effectively (especially in a period of changing policy stance and market turbulence). We think that the SNB has undoubtedly been successful in achieving this.

For these reasons, and as we argued in the past, it would make sense for the SNB to raise rates to a neutral level before any eventual slowdown materialises next year (which we indeed think is likely). This would give the SNB useful ‘extra’ ammunition next year if borrowing costs needed to be cut so as to accommodate a slowdown. If global credit conditions worsen or US economic conditions deteriorate more than expected, such a hike would not be possible in March (the next SNB meeting). Also, the lags in policy transmission would make it more adequate to raise rates now (as the economy is still strong).

What is the most likely CHF path?

We still think that the CHF will appreciate in the coming weeks and into next year. The most obvious trades remain long CHF against late cycle economies. The US, the UK in particular, and probably Canada represent the most obvious candidates. Despite the recent sharp appreciation of the CHF against these economies, we think there is room for further gains. In the case of Canada, the recent BoC decision and the possibility that the market may price in more ‘re-coupling’ with the US going forward make this a good relative value trade. The pace of this strengthening will also likely depend upon the Swiss Libor path, not necessarily because of the narrowing carry (although it should matter a bit, even in the current context), but mainly because of the signals the SNB would give in terms of underlying fundamentals amid global uncertainty.

In simple terms, these signals would be: (i) The economy is resilient as a whole, and growth may slow from a higher level than expected back in September; (ii) Inflation is a medium-term concern; and (iii) The financial sector is able to cope with a 25bp increase in the 3-month Libor rate.

EUR/USD is important for the SNB

The resilience of the euro area is not only important for Swiss external growth, but also from a EUR/USD perspective. If Europe does not show signs of strong weakness and the EUR/USD accordingly remains relatively supported, the EUR/CHF, while likely decreasing, would do so in an orderly fashion, so that the risk of sharp EUR/CHF depreciation would be less of a threat to the SNB.

Bottom line

It is a close call, but the SNB will likely raise rates next week. This will make a difference to the pace of CHF appreciation going forward. Our bias remains for the CHF to appreciate against late cycle economies.

By Luca Bindelli London
Morgan Stanley
December 7, 2007