What to Look for if the Market Wants to Challenge the SNB

Since Sept 6, when the SNB surprised the world by putting a floor under the euro at CHF1.20, the market has not deigned to challenge it, despite the continuing pressure in the euro zone debt markets, where spreads continue to widen and CDS prices continue to rise. This is true for banks, many corporates, along with sovereigns. So while the conditions that led to the Swiss franc;'s overshoot remain in place, euro-Swiss has been in narrow ranges above the CHF1.20 floor.

The market will likely eventually challenge the SNB's resolve. What are some of the potential signs that the market is beginning to gear up for such a test?

The first place to look might be volatility, even if one does not trade options. Three month volatility tends to be a benchmark. In early Aug (Aug 9), 3-month euro-Swiss vol hit 26.5%, fell back to about 15% before heading back to 20%, which is around where it was when the SNB made its announcement. Three-month vol collapsed to just below 8.2% on Sept 8, but firmed up to 10.7% yesterday. It is slightly softer today, but a continued trend higher maybe an early warning sign that the market is preparing to test the SNB.

Shorter dated volatility, such as a week or a month tends to track spot on a contemperanous basis and may not offer as much of a lead indicator. That said, one week vol is make a new low today just below 6.5% from a high yesterday near 11.35%, which was the highest since the new currency/QE regime.

The equity market should also be monitored. The strength of the franc was a key factor undermining the attractiveness of Swiss corporations, many of which rely heavily on foreign sales. The weaker Swiss franc appears to have helped steady Swiss equities. Thus far, here in Sept, the Swiss Market Index, off 3.65%, is among the best performing major equity markets and over the past month, it is the only one showing a gain (albeit, modest near 1.3%).

Switzerland's Market Index is highly correlated with the euro-franc cross. On a 60-day rolling basis (percentage change), there is roughly a 62% correlation and on a 30-day, the correlation is near 60%.

The SMI peak was last April 2010 near 6990. By early last month, it hit a low just below 4700. It lost nearly 1/3 of its value. However since early Aug it has bounced, but that bounce ran out of steam near the minimum technical retracement (38.2%), which comes in near 5572. The SMI gapped lower on Monday and despite today's modest uptick, has been unable to fill that gap, which is found between Friday's low (5430.77) and today's high (5372.10). If that gap remains unfilled and the SMI heads lower, it may be a sign of renewed upside pressure on the franc.

The SNB holds its quarterly policy review this Thursday. After the recent policy move, that included lowering the 3-month LIBOR target to 0-25 bp from 0-75 bp, new fresh initiative is likely to be forthcoming. However, there has been some speculation that the SNB may chose to manage its new foreign currency holdings differently, such as the creation of a sovereign wealth fund, or chose not to mark-to-market part of its reserves.