SNB seems relaxed from weak Swiss franc, Citi report

The Swiss Franc’s (CHF) ongoing weakness — the EUR/CHF rate is at a record high — is unlikely to prompt the SNB to shift away from the “on hold” stance signaled at the September policy meeting, according to Citigroup research dated 11 October. This does not mean that the SNB pays no attention to the EUR/CHF rate. Rather, like many inflation targeting central banks, the SNB judges the inflationary effect of currency swings in the context of other factors. And, right now, with continued money market strains plus weak 3Q inflation and hints of softer growth, the SNB can tolerate some modest currency weakness. For now, the SNB remains on hold, adds Michael Saunders from Citigroup.

In 2Q, the SNB reacted hawkishly to previous highs in Euro/CHF by hiking 25bp in mid- June, warning of further tightening to come. By lifting the repo rate again in late-June, it triggered speculation about an accelerated pace of tightening thereafter. However, although euro/CHF is back above those levels (i.e. record weakness in Swiss franc versus the euro), the SNB currently remains relaxed. The SNB has continued to trim the oneweek repo, which now stands at 2.05% (versus 2.43% in late June), and SNB Governor Roth made calming comments after a speech on October 9.

Several factors explain the SNB’s more relaxed approach to CHF weakness, notes Saunders:

The trade weighted CHF is not as weak as euro/CHF, and remains slightly above the mid-year lows. Although the CHF has fallen against the euro, it has been roughly stable against the GBP in recent months and risen against the USD. Moreover, with low Swiss inflation in recent years, the real trade weighted exchange rate is not far from record highs.

Lead guides give further hints that the downside growth risks highlighted in the SNB’s September statement are materializing. The OECD’s leading indicator for Switzerland is down 0.7% YoY in June-August, the weakest since 2002.

Moreover, the September PMI plunged 7.5 points, the sharpest MoM drop since the index began in 1995. Business surveys and lead guides for key trading partners — the euro area, U.S. and U.K. — also have been softer.

Money market strains remain unusually severe, adding to future downside risks to growth. The spread between 3-month libor and the one-week repo is still unusually high, at 70-80bp, versus the average of 20bp during 2004-06. Spreads between interbank rates and market expectations for central bank policy rates also remain unusually high in the U.K., the euro area and the U.S. The longer the money market crisis persists, the more it will be reflected in wider lending spreads and tighter lending standards for businesses and households. Evidence of this already is evident in surveys in the euro area and U.K., and the same probably is happening in Switzerland as well.

Inflation has remained subdued, with CPI inflation at 0.7% YoY in 3Q. This is well below the SNB’s forecast at the start of Q3 (1.0%), and comfortably below the 2% target ceiling. In particular, despite CHF weakness in recent years, prices in the CPI for imported items ex oil have remained slightly down YoY.

By contrast, in June, the potential inflationary threat from the weak CHF was exacerbated by high economic growth, an overshoot in 2Q inflation versus the SNB’s forecasts, plus ongoing stimulus from low credit spreads and easy credit availability. The overall picture was of rising inflation risks. Currently, with the other headwinds of growth, modest CHF weakness does not pose an immediate inflation threat. It follows that if the CHF gently weakens further amidst increasing downside risks to growth, then the SNB will remain relatively relaxed about upside inflation risks. Conversely, if money market spreads and credit spreads were to narrow sharply — hence improving growth prospects — then the SNB will become more hawkish even if the CHF does not weaken further.

To be sure, the SNB still has some long-term inflation worries (as evident in its September statement), but with inflation currently so low and rates already up 200bp since late 2005, the central bank has time to see how the current crisis unfolds before possibly hiking again. For now, our base case still envisages one final hike (to 3.0% for the centre of the libor band) in 2008, but even that final hike may not be needed if money market strains persist and downside risks to growth continue to accumulate.