ECB will test Swiss resolve to defend currency come what may

• Swiss National Bank reiterates its call to keep EURCHF at 1.20
•  Failure to hold level could bring on a “waterfall” effect
• The Swiss can sell CHF but is that sustainable for the SNB’s balance sheet? 

Nobody will be watching today’s flash estimate of Eurozone August CPI closer than the Swiss National Bank (SNB). Analysts are saying that a weak number will reinforce expectations that the European Central Bank Governing Council will foreshadow a quantitative easing program at its meeting next Thursday. That would add pressure on the EUR and, in turn, EURCHF.

The Swiss National Bank announced with great fanfare in September 2011 that it would draw a line at 1.20 on EURCHF and defend it resolutely. At its most recent monetary assessment (19 June) the Bank repeated the party line:

“With three month Libor close to zero, the minimum exchange rate continues to be the right tool to avoid an undesirable tightening of monetary conditions in the event of renewed upward pressure on the Swiss franc. The SNB will continue to enforce the minimum exchange rate with the utmost determination. If necessary, it is prepared to purchase foreign currency in unlimited quantities for this purpose and to take further measures as required.”

Switzerland inflation CPI

Source: Tradingeconomics.com

This determination was perhaps easier to express then when EURCHF was close to 1.22 than it would be today with the cross getting menacingly close to the 1.20 limit.

As events have unfolded, it seems the SNB has backed itself into a corner with bellicose language and it may well find its bluff called in the next couple of weeks. EURCHF will be under pressure not only because of EUR weakness but on account of the Swiss franc’s long-standing safe haven status, which comes into play during times of geopolitical tension.

Nevertheless, the Swiss, emboldened by previous success in defending the exchange rate floor, will not give in without a fight and will likely sell CHF as the cross rate approaches the 1.20 floor, the first time it has had to do so since late 2012. In theory, they can sell in unlimited quantities – as mentioned in the June statement – but it is questionable that is a sustainable option for the SNB’s balance sheet.

It also has another option in its tool kit, as alluded to in the statement, namely “further measures as required”. The most significant of these further measures would be to follow the European Central bank and introduce negative deposit rates. Indeed the Swiss National Bank President Thomas Jordan said last December that if the ECB dropped its deposit rate into negative territory he would respond in kind. This would be a powerful move by the SNB given the large size of deposits it holds and if the exchange rate remains under upward pressure when the next monetary statement is released on September 18, we may well find in it an announcement along those lines.

It is worth remembering this is far from just academic exercise to the Swiss. In the March, the International Monetary Fund (IMF), in its review of the Swiss economy, encouraged the SNB to stick to its policy of defending the exchange rate floor or risk the onset of deflation. As the chart below shows, there is not much room for error.

 EURCHF weekly chart

Source: Reuters

But the elephant in the room is the ECB and there is little the Swiss Central Bankers can do but await developments on that front. Swiss GDP is barely 5% of that of the Eurozone and the perilous level of the EURCHF cross is unlikely to be high on the agenda when the ECB Governing Council meets on September 4. 

The mechanics for full-blown quantitative easing in the Eurozone are not in place (let alone the politics), but Mario Draghi’s post meeting press conference will be an opportunity for him to up the ante on the threat to use “unconventional measures” to achieve the ECB’s inflation target. No doubt his Swiss counterparts will be hoping that whatever he says or does will have minimal impact on EURCHF.

That may be wishful thinking. The charts below show that failure to hold the 1.20 level could bring on a “waterfall” effect, driving EURCHF appreciably lower, and forcing the SNB to the sidelines. Alternatively they could mount an orderly retreat and simply announce a lower “line in the sand”.

Chart: EURCHF daily chart (click to expand)

Source: Reuters

Regardless of the factors conspiring against EURCHF, no doubt many traders will pin their faith in the SNB and buy as it dips towards the floor, seeing a good risk-reward trade backstopped by a determined central bank with a formidable track record. Indeed, that is what the highly-regarded CitiFX technicals team did yesterday. But within hours they had pulled the trade, declaring it “maybe not such a good idea”. After feedback the risk level might be a good deal higher than they had assumed.

By Max McKegg -- Edited by Adam Courtenay