Swiss Franc Now Two-Way
When the Swiss National Bank hiked its benchmark sight deposit rate by 50bp in June, it also arguably reversed over a decade of orthodoxy in pledging to sell foreign exchange reserves if necessary to support the franc. Perhaps far ahead of other G10 central banks, the SNB realised that franc strength would now be critical to combat inflation via the pass-through channel. The Riksbank has now adopted a similar stance on the krona, and various European Central Bank members also appear to have grudgingly acknowledged this transmission channel. In G10, the Bank of Japan is the only outlier in this respect.
Even so, we note the past week has not been straightforward for the franc. The market appears to be having second thoughts about the currency being a one-way bet, especially against the euro. In iFlow, the franc has recently been one of the worst performers, but we suspect that much of the CHF sales were being done on the dollar leg. After all, even with its surprise hike and hawkish outlook, the SNB remains one of the few negative-rate central banks globally. Investors whose base currency is not the franc will enjoy a strong yield pick-up if their CHF-denominated investments are hedged. Conversely, hedge ratios on overseas assets for CHF-based investors could also be falling given the increasingly prohibitive cost.
Fundamentally, we believe the market has acknowledged that the deteriorating outlook for the Eurozone could force the SNB to introduce greater downside risk to its current outlook. June’s rate hike pre-empted any ECB decision, but we doubt that the SNB would have taken this step without a relatively benign assessment of the Eurozone economy. This judgement was correct at the time as the subsequent June ECB staff projections signalled sustained growth. However, three months on it appears the ECB’s downside scenario entailing a near-2% contraction is now becoming the market’s base case. It is inconceivable to us that the Swiss economy can expand robustly if the Eurozone is facing a deep recession.
This is where we think the SNB will need to exercise stronger guidance regarding its tolerance limits to franc appreciation. As the chart below shows, on a nominal effective exchange rate (NEER) basis the franc is now at a two-decade high. Furthermore, there has been a near-10% increase in the NEER since the end of 2019 – but that has done nothing for inflation. For much of this period, the price drivers for Switzerland have been input/supply-based. The SNB will likely remain of the view that a strong franc can help contain such pressures. The inflation trend – and by extension, inflation expectations – has firmed, resulting in the SNB’s acceptance of franc strength as a policy tool. More recently, the domestic situation has taken precedence, but the SNB clearly communicated that rates would be the main transmission mechanism to slow demand.