There is a grey zone should the ECB decide to cut 30bp or so. It is more unclear how franc-inflows could react to such a scenario. In this case, we think, the FOMC decision coming on 17 December could become very important. If the FOMC hikes rates for a first time, the franc’s nominal effective exchange rate could benefit from further depreciation against the USD. However, should the Fed decide not to hike, we could see the SNB cutting under such a scenario, too.
If needed, SNB might prefer FX interventions to deposit rate cuts
It is unclear how far into negative territory interest rates can go before adverse effects materialise. So far, only the Riksbank cut its deposit rate further than the SNB, at least on paper. However, the Riksbank also lowered financing costs by cutting the repo rate to -35bp. Furthermore, Sweden’s depo rate of -110bp is charged on a very small proportion of deposits (SEK 74 million in October), while the bulk of deposits stays in “fine-tuning operations”, which are remunerated in a 10bp corridor around the repo rate (SEK 28.6 billion). The Danish central bank currently equally charges 75bp on its deposit facility, but allows banks to park almost half of their deposit in a current account, which is free of charge.
The SNB continues to exempt roughly 20 times the required reserves from the negative deposit rate – in total, some CHF 290bn of domestic sight deposits, therefore, are still free of charge (although this may vary from bank to bank). However, domestic sight deposits stood at CHF 402bn at the end of November, which means that a large chunk of deposits is no longer exempt. Assuming the total excess deposits of CHF 112bn to be charged at the deposit rate, the banking domestic sector currently has to pay some a little more than CHF 0.8bn deposit charge to the central bank, equivalent to almost 4% of Swiss banks’ gross profits in 2014.
Adverse effects on bank lending have already started to materialise: in order to offset the charges on deposits, Swiss banks have started to increase the mortgage lending rates since the beginning of the year. From an SNB perspective, this may be welcome, as it limits further built-up of housing market exposure of banks through mortgage lending. However, cutting the interest rate even further may amplify the risk of liquidity being simply reshuffled from deposits directly into real estate and increase the burden on the domestic banking sector. Ultimately, therefore, we think the SNB’s preferred policy tool at this stage are FX interventions.
FX: Relative calm after the storm
One of the most notable features of price action since the October 22nd ECB press conference is just how resilient EUR/CHF has been since ECB President Draghi effectively signalled that further unconventional policy measures were in the pipeline. Indeed, since that meeting, the EUR has underperformed versus all of its G10 counterparts with the exception of CHF. Both monthly FX reserves and sight deposit data do not suggest that the SNB was compelled to support EUR/CHF during this period, suggesting that capital inflows have slowed significantly relative to the past year.
The dynamics of capital inflows have been a constant theme in recent speeches by SNB President Jordan and perhaps provide the single most important factor driving EUR/CHF performance since the end of the intense phase of the Greek crisis. It is an indication of how idiosyncratic the Greek risk was for CHF that the China inspired volatility spike in August barely registered for CHF as JPY, EUR and even SEK performed more strongly during that period.
Though EUR/CHF is still nearly 10% below the pegged level, the SNB will be somewhat reassured that since September, the pair has traded in a 1.07/1.10 trading range. The cross may not have appreciated as the SNB would like, but at least it has not depreciated, despite the increasingly volatile global environment. Furthermore, in TWI terms, CHF has retraced over 60% of the January appreciation driven largely by USD/CHF and GBP/CHF trading back to their respective highs for the year.
As highlighted above, the scale of the ECB move will be the critical driver for CHF in the immediate aftermath of the announcement. We would note that of the range of Bloomberg estimates for the ECB deposit rate, the maximum scale of the cut is expected to be 25bps. This would still leave SNB rates 30bps below their Euro Area counterparts. Even with the heightened focus around the size of the ECB deposit rate cut, EUR/CHF has remained relatively stable and is currently trading at the October highs.
Swiss domestic investors recycling overseas
Whilst the market nervousness over the implications of further ECB easing on CHF are understandable, we believe that the concerns that the Swiss economy would experience significant capital inflows are overstated. Swiss rates will likely remain more negative than in the Euro Area following the ECB decision. Investors are therefore unlikely to see Switzerland as an attractive investment alternative. Without an associated idiosyncratic risk to Euro Area, potential capital outflows from the Euro Area are likely to find a home in higher yielding locations such as the UK and US (we note that non-resident purchases of UK gilts rose to their highest levels for the year in October). Indeed, Swiss domestic investors have already indicated their preference to invest overseas according to the most recent balance of payments data.
In our view, Swiss domestic investors buying overseas assets is likely to be the more significant driver for CHF underperformance in 2016 if this trend continues. Furthermore, our measure of the broad basic balance of payments already suggests that current account surplus is being largely offset by the financial account balance (net portfolio plus FDI flows). Absent another GREXIT style shock to the Euro Area economy, we believe that the marked overvaluation of the CHF that we have highlighted in the past will continue to correct itself.