EURCHF floor could become collateral damage if ECB ups the ante

The Swiss National Bank has again pointed to the line in the sand that must not be crossed: EURCHF at 1.20. But the markets are holding European Central Bank President's Mario Draghi’s feet to the fire, demanding more action as the ECB’s inflation target fades from view. These forces are set to collide in a titanic struggle.

 

The SNB last week released its quarterly monetary policy assessment and it made for bleak reading. The economic outlook is seen to have deteriorated considerably since the June assessment, the risk of deflation has increased and the CHF remains too high.

 

A titanic struggle could be in the offing between the SNB and the ECB. Photo: Thinkstock

The exchange rate floor of EURCHF at 1.20 was maintained and the policy rate target range was kept at 0.00% to 0.25%.

In reality, the three-month Libor rate is effectively zero-bound, so the exchange rate floor is seen as the key instrument to avoid an undesirable tightening of monetary conditions. Hence, this will be defended “with utmost determination” and to do so, the SNB is prepared to purchase foreign currency (by selling CHF) in “unlimited quantities”.

 

If necessary it will take “further measures immediately”. This is a threat to drop the policy rate deeply into negative territory if the floor is broken.

 

The problem for the SNB is illustrated in this chart. Its forecast for inflation continues to decline in response to a deteriorating global economy and slower growth in Switzerland. The consumer price index in 2016 is expected to be trending at only 0.5%, leaving little margin for error before deflation overwhelms them.

Source: Swiss National Bank 

The determination of the SNB to hold the value of the CHF at current levels, and preferably to see it decline, is understandable given the damage done by the surge in the real effective exchange rate beginning in 2010, as shown in the chart below.

 

Since then there have been some hard-won gains and the bank is determined not to see them reversed.

Source: Pictet  

The ECB is compelled to act by its inflation mandate

 

But, of course, there are two balls in the air when it comes to EURCHF, and developments in Eurozone monetary policy threaten to overwhelm any action the SNB might take to defend the 1.20 minimum exchange rate.

 

Draghi said yesterday in his quarterly testimony before European Union leaders, that the ECB was moving to a more “active and controlled management of our balance sheet” as the risks around the expected economic expansion are heading in the wrong direction. That in turn threatens the bank’s mandate to produce an inflation rate of close to, but below, 2% over the medium term.

 

The markets doubt current policies will meet the mandate. Draghi was given the benefit of the doubt after his tough-talking Jackson Hole speech, as demonstrated in the chart of the five year/five-year forward inflation swap. This is the ECB’s preferred measure of inflation expectations.

 

After an initial bounce, the swap rate has declined to record a new low.

Source: Bloomberg 

Quantitative easing via a mixture of security purchases is required

Reversing these negative trends will require decisive action from the ECB. In early October, it will give details of the asset purchase program previously announced. This will involve outright buying of Asset Backed Securities (ABS) and covered bonds. There are approximately EUR400 billion of suitable ABS on issue and EUR 1 trillion of covered bonds. 

The ECB intends to expand its balance sheet by around EUR 1 trillion, so if it does this by buying ABS and covered bonds only, it will effectively take over control of those markets. More likely they will add selected sovereign debt to the mix.

 

The reference to “outright buying” means that the security purchases will not be sterilised. That is the definition of quantitative easing.

A decline in real interest rates is what the doctor ordered

The aim of the exercise will be to drive down real interest rates in a similar fashion to that achieved successfully by the Bank of Japan. An aggressive policy of balance sheet expansion via purchases of government bonds sees Japan now with inflation running at 1.3% and a 10-year bond rate of around 0.5%. So that’s a negative real yield of about 0.8%. 

The theory is this will incentivise “economic agents” (i.e. consumers and business) to increase spending and investment respectively, while also raising inflation expectations.

 

Contrast this with the situation in the Eurozone where real interest rates are still positive at the long end of curve.

 

The ECB has plenty of room to move, as shown in the chart below.

Source: ThomsonReuters data stream

The SNB will be very nervous as we head into October with the probability of more action from the ECB hanging over its head. While it talks tough, the SNB is a relative minnow compared with its Frankfurt counterparts, so the EURCHF floor could become collateral damage when Draghi ups the ante. 

The Swiss still have one trump card in their hands – dropping the policy rate deeply into negative territory – but they will be forced to play it shortly.