SNB Pledges New Managed Float to the Euro

BBH CurrencyView

• Morning dominated by SNB’s decision to target EUR/CHF at 1.20; European stocks marginally higher
• German August orders slumped -2.8%, first drop since March; US service-sector ISM key report today
• In the EM space, China’s economic growth may ease to below 9% in 2012; RBA turns neutral

European stocks are marginally higher from yesterday’s closing lows with the Euro Stoxx 5o index up 17.5pts, or 0.8%, to 2126.62, led by strong rebound in basic materials (+1.8%), healthcare (2.6%) and utilities (+1.2%). The Dax and the FTSE 100 remain below the key 5500 and 5200 levels, signaling continued caution, though the markets are consolidating following yesterday’s losses with SNB and ECB activity in the markets benefiting liquidity and flows. However the mood has improved noticeably since Monday’s session following news that the ECB is back in the market, which lowered Italian 10yr bonds yield 9bps to 5.45%, while Spanish yields fell 6bps to 5.16%. Benchmark bund futures are down 80ticks on yesterday’s record highs, although 10yr Bund cash yields remain in ultra-defensive territory below 2%, though up 6bps at 1.90% on the day. US equity futures remain pressured, however, with the Sep11 Dow contract showing a three-digit loss after the stock market volatility of recent days.

In the G10 space markets continue to digest the news that the SNB has set a minimum EUR/CHF exchange at 1.20.This was indeed a bold move by the SNB in an attempt to quell broad SNB strength, which according to the BIS’s nominal broad trade-weighted index increased by over 15% year-to-date and has begun to sap growth. The central bank said in its announcement that it is willing to buy unlimited foreign currency and will defend its FX target with "utmost determination", as the current massive overvaluation of the Franc is posing deflation risks. The announcement comes after CPI inflation fell to 0.2% and as the SNB is running out of options with rates already at almost zero and other measures appearing feckless. In fact, the recent financial losses associated with the SNB’s failed intervention attempts have attracted strong criticism. All told, we expect that while a managed float to the euro is likely to provide some support for the Swiss economy in time, we suspect that in the end exogenous shocks are likely to prove to be strong headwinds for the Swiss economy and the SNB’s goal of a cheaper currency. German August orders, which slumped -2.8% and the first drop since March, add to our view that the euro is likely to remain on the downside of its recent, broad range near $1.40. The euro drivers we track, such as rate differentials, European financial shares, credit spreads and market positioning (among others), continue to indicate that the euro is likely to remain heavy on the crosses, with risk reversal skew suggesting extreme euro bearishness. Despite the euro’s recent resilience amid the intensification of the sovereign debt crisis, many will look to the ECB meeting this week for guidance. We suspect that the ECB is unlikely at this juncture to retract its prior 50bps hikes, yet a dovish press conference would exert a potentially strong near-term influence on the euro, by acknowledging that growth outlook for the real economy has considerably weakened.

In the EM space, China’s economic growth may ease to below 9% in 2012. This is due in part to a weak global economy, said a senior Chinese foreign exchange official, backing expectations that the world’s second largest economy is set for a soft landing. Chief economist, Guobo, at China’s SAFE said even as the economy cools, inflation is still a policy focus for Beijing in the coming months. At the same time, Reuter’s poll in July showed analysts expect China’s economy to grow 8.8% in 2012, down slightly from 9.3% in 2011. The mild slowdown in growth is still well within Beijing’s five-year economic blueprint ending 2015, which China Premier Wen Jiabao said the economy should grow an average 7% over the period. According to Reuters many economists see 8% as a critical line because growth below that level may not create enough jobs to keep up with China’s rapidly urbanizing population. We continue to expect China to avoid a hard landing off driven in part by the ongoing V-shaped recovery in Japan, which in turn is likely to be supportive of Asian growth in general. And while we suspect that EMs in general are unlikely to fully decouple against the current market backdrop, we suspect that a world of tepid US growth and a muddle-through in Europe is likely to buoy capital flows to EM, Asia in particular. Elsewhere in Asia, the RBA left rates unchanged at 4.75% as expected, though it appears the RBA has shifted to a more neutral tone. The central bank issued a similar statement to that issued at the last meeting highlighting concerns about high domestic inflation levels and global risks. We see no signs of a near-term rate cut here and suspect that the five 25bps priced into the OIS curve are too dovish. Nonetheless, we expect the AUD to remain in a narrow range supported by the 200dma near 1.04.