Swiss Surprise, but France More Telling

The Swiss National Bank took the market by surprise by announcing what amounts to another version of quantitative easing.  Its first attempt was via foreign bond purchases and sales of Swiss franc for euro and dollars.  It failed miserably and leaving the august institution with significant paper losses.

This new attempt includes: 1) a formal adoption of a near-zero interest rate policy, 2) a cessation of renewing maturing repos and SNB bills, while actively repurchasing bills, to achieve 3) a substantial increase in sight deposits to CHF80 bln from CHF30 bln.  In June, repos and bills outstanding stood near CHF25 bln and CHF107 bln respectively.  This leaves it plenty of room, if needed to overshoot its CHF80 bln to the upside, indicating some ability to scale today's policy response to what by all metrics is a terribly over-valued Swiss franc.
  

The net effect will be to create negative interest rates on CHF deposits for foreign wholesale holders of Swiss francs.  It will now cost buyers of Swiss franc buyers to hedge the euro risk, which appears to be the main driver in launching the Swiss franc into the stratosphere.   

The net impact of these measures, outside of the knee-jerk reaction is difficult to ascertain as even a small cost of hedge may be seen as worthwhile if the tensions in the euro zone continue, and signs point in that direction.   It is likely to make the Swiss franc more volatile rather than less especially during periods of increased stress.  

There has been some talk that the SNB action may force the BOJ's hand at the policy meeting later this week.  Color me skeptical.  Japan already has near-zero interest rate policy.  Its track record on unilateral intervention is poor at best and implied volatility has actually come off a bit this week (3-month implied from 11.45% at the end of last week to around 10.70% now.  

With the assessment of the Japanese economy improving (BOJ and government) the risk of expanding QE now still strikes me as low.  That said, the decline in the Nikkei did appear to trigger new buying of ETFs and REITs under the existing program.  

The European debt crisis seems to be a major force that has driven the Swiss franc to record highs.  The crisis is far from resolved.  Peripheral premiums over Germany and CDS prices are generally higher now than before Europe's new measures to stem the crisis.  

The recent PMI reports have been considerably weaker in Spain than in Italy, but the Italian bond market is focus.  Yesterday's rumors that Italy was going to cancel Aug and Sept bond auctions were quickly denied and for good reason.  In Sept alone Italy reportedly has 46 bln euro of bonds maturing.  It could, if yields stay elevated,  resort to syndication or private placements, but Italy's maturity and interest payment schedule forces it to issue. 

Some pressure on Italian bonds may reflect some investors calling Europe's bluff.  The new flexible EFSF is still weeks, if not a couple of months, of being operational.  And even when if can buy stressed bonds, it requires unanimity in the decision, which allows Germany to attach conditions or brandish a veto.  Preemptive/precautionary lines of credit similarly sounds good on paper, but operationally, the conditions and time frame are not clear.   

Nor should investors be particularly concerned about the possibility that the ECB resumes its sovereign bond purchases, with an eye to Italy (and Spain).  It would do so reluctantly and that translates into size that may not be market significant.  Recall that ECB Greek, Irish and Portuguese bond purchases do little but shift ownership from private sector to ECB and there did not seem to be a significant impact on yields or liquidity. 

Perhaps though it is not Italy, but France that offers a more interesting/compelling way to play the European debt crisis.  Today France is paying a larger premium over Germany than any time since the birth of EMU.   It is not so much because of French macro economic situation, though its seems to be barely holding on to its triple-A rating.  Rather the function that a short French bond position does is provide a less volatile way to express an expectation of increased euro zone tensions, especially in Spain and Italy.   

As pressure mounts on Spain and Italy, the risks increase that they will seek ways to drop out of funding the assistance programs for others.  Currently, for example, the two of are to contribute a little less than 1/3 of the EFSF funds.  If they drop out the proportion accounted for by France and Germany rises to near 3/4.  That extra burden will require new fiscal measures by France, who goes to the polls next year, and Germany, where the assistance has already prompting tighter fiscal policy, given their "balanced budget amendment".   

Note that the French 5-year CDS was near 100 on July 21 as the draft of the euro zone statement was reported.  Today it is near 137, which appears to be a record high.   Germany's 5-year CDS is priced at less than half France's.  Spanish CDS prices are around 3-times France's at 415 and Italy's 363 is 2.5 times higher than the French quote.  

BOE and ECB meet tomorrow.  The MPC will not be under any urgency to change policy.  However, the minutes may show that the hawk camp is losing some support.  Trichet may brandish the threat of buying more sovereign bonds, but his interest rate signals are more important.  Prior to the recent flair up of tensions, the market had anticipated another ECB hike in Q4, likely early on during Draghi's tenure.  In recent weeks the liquidity effect has seen short-term rates fall, but the preliminary signs suggest that the engine of European growth, Germany, is stalling out.  

Numerous surveys--ZEW, IFO, PMI, and VDMA all confirm that the German economy is lost momentum.  It will report Q2 GDP on August 16th and growth of 0.5% (quarter-over-quarter) while respectable--for Germany--feels bad because it represents a marked slow down from the 1.5% growth reported in Q1.    The slowing of the German economy and the fact that it just hiked rates for the second time in the cycle, the risk is that Trichet's comments are interpreted more dovishly by the market.  

However, the US jobs data on Friday may be key for the dollar's near-term direction.  A disappointing report will only fan the speculation of QE3.  The poor growth in H1 means that the Fed's GDP forecasts (~2.8%) are too high and the fiscal drag next year may require it to cut next year's forecast as well (~3.5%).  Given the extremely low risk of deflation, the trade-offs that Bernanke has spoken about, still do not appear in favor of QEIII.  Although Martin Feldstein has opined that there is a 50% chance of another recession, the policy market intrade.com show about a little less than a 30% chance.  It stood near 40% a year ago.