The market is still trying to make sense of yesterday's bombshell by the Swiss National Bank to abandon its franc cap, which affirmed as an integral part of the central bank's monetary policy a few short days ago. Not only were market participants taken by surprise, but apparently so was the IMF and the ECB.
Since the franc cap was imposed in 2011, there have been times when for one reason or another some, including ourselves, thought it could be abandoned. However, the SNB did not relent. Last month, when adjusted for swings in prices, it appeared the SNB intervened by buying around 20 bln euros to defend the cap. It appears that the SNB accepted that it reached a fork in the road. Given the prospects of continued euro depreciation and outflows from Russia, where the ruble is off almost 7% this year, the SNB would have to double down on its efforts to defend the cap or abandon it. It chose to abandon it as the lesser of two poor choices.
We find much of what is passing for analysis of the Swiss decision is speculators talking their books. Judging from the recent Commitment of Traders in the futures market and the losses suffered by several retail platforms, the speculative market was heavily biased toward short franc positions. At one point, yesterday, the Swiss franc appreciated a little more than an unprecedented 40% against the euro. It is a painful reminder that those who make money in the market do not do so by being right more often but by disciplined risk management. There is no short cut.
Some observers argue that the Swiss experience proves that fighting "free-market" forces or pegged regimes are unsustainable. Yet several pegs remain, like the Hong Kong dollar and many Middle Eastern currencies. On the Swiss news, the market immediately took the Hong Kong dollar to the strong side of its band, but the peg (really a cap) has not been broken. The market did not break the SNB cap as it did, say, the peg in Mexico in 1994-1995 and Asia in 1997-1998. The SNB abandoned its strategy.
The SNB's decision does not mean that it will accept a free-floating currency. We suspect that it may still accumulate some euros. Given that it reports its reserves in Swiss franc terms, valuation adjustment alone will point to a dramatic surge. However, it can be much more flexible in smoothing the currency than having to defend a Maginot Line. As one would expect, it will take the market some time to find a new equilibrium. The euro-franc range today is around five percent and the Swiss stock market is off about five percent as well. The 10-year benchmark yield is negative nine basis points.
Participants are linking the SNB's move to the prospects of the ECB's move next week. To the extent that the anticipation of a sovereign bond buying program that will weaken the euro was behind the SNB's decision, it drives home another point—sometimes in the capital markets, the cause takes place after the effect. While this may seem counter-intuitive, the anticipatory nature of participants, both official and private, is a fundamental characteristic.
The market is generally anticipating that the ECB will announce a new 500-700 bln euro asset purchase program. The market did not seem to react to ECB's Coeure suggestion that to be effective the bond buying program needs to be large. Because even at this latest data the Bundesbank’s Weidmann and others are still reluctant to endorse a sovereign bond buying program, many suspect a compromise that will limit the size and risk to the ECB itself.
That said, there are two important considerations. First, it is not a done deal that such a purchase program is announced next week. At last month's press conference, Draghi made it a point, not to commit to the January 22 meeting, and explicitly referred to the March 5 meeting as well. Subjectively, we would place the odds of an announcement next week at around 70-75%.
Second, Draghi and the ECB have been specific about their desire. The intention is to return the balance sheet to its earlier peak. To do so requires around 1 trillion euros. The covered bond and ABS purchase scheme and the TLTROs may conservatively get the ECB almost half way there. This does not seem like a case for shock and awe, but rather a modest program, especially when compared with the Federal Reserve or Bank of England experience, let alone the extremely ambitious Bank of Japan efforts.
The slippage of euro area CPI into negative territory (-0.2% year-over-year) was confirmed today. The core rate was revised lower to 0.7% from 0.8%. The core rate is evidently less important to the ECB than the headline rate, even though it provided poor policy signals such as in 2008 when Trichet led the central bank to hiking rates just before the bottom dropped out, and it entered a prolonged recession.
Aside from trying to make sense of the SNB's move, the North American session will be dominated by two things: a flurry of economic data and the price action itself, notably a likely continued correction in US shares and a fall in yields. The S&P 500 closed on its lows yesterday and is likely to gap lower at the open. We have found the gaps to be technically important. A break of the mid-December lows in the 1972-1973 area would be significant. The next immediate target would be in the 1957-1960 area. US 10-year yields slipped to near 1.70% yesterday. They are holding just above there now. A break of it would suggest potential to 1.60% on the way to 1.5%.
The data may encourage such moves. Headline CPI may be nearly halved to 0.7% from 1.3%. The core rate will prove stickier, but investors should be prepared to see a negative year-over-year print in the coming months. Industrial output is likely to be soft. The consensus expects a 0.1% decline after the outsized 1.3% gain in November. Manufacturing output likely cooled at the 1.1% increase, though it may still eke out a small gain. Capacity utilization is expected to have slipped back below the 80% threshold. Going into today’s data, the Atlanta Fed’s GDP Now sees the US economy tracking 3.4% annualized growth in Q4 14.