More Swiss policy tightening, but how?

 

End of an era

Concluding seven years of negative interest rates, the Swiss National Bank (SNB) tightened monetary policy at its September meeting, warned that further rate increase could be necessary and joined other global central banks in foreseeing significant risks to the global economy. Lifting base rates by 75bps to 0.50%, the bank also raised its inflation forecasts and unveiled measures to manage excess liquidity.

Going forward, we expect the SNB to retain its firm stance in a fast-changing and often uncertain macro environment, with the Swiss franc and potential balance sheet reduction being key policy levers. As, in our opinion, it reaches its peak speed of rate rises, we highlight that SNB communication has been smoother than its peers and we believe credit valuations look compelling.

 

Expectations reprice higher

The size of the 75bps rate hike was smaller than the 100bps predicted by markets yet still in line with economists’ predictions. The SNB reaffirmed its willingness to be active in foreign exchange markets as necessary. Larger rate increase expectations reflected the substantial re-pricing of projections following Federal Reserve chairman Jerome Powell’s hawkish tone at Jackson Hole in August but proved to be unfounded.

The bank also announced technical details to ensure the good management of excess liquidity. It adjusted its tiered remuneration of the sight deposits that banks and other financial market participants hold at the SNB, and it will absorb liquidity through open market operations. The intention is to ensure banks pass on SNB rates - we believe that larger credit lines stand to benefit first from the measures whereas there will be some time lag for a pickup in competition across banks and hence in transmission to smaller clients.

The SNB raised its conditional inflation forecasts in the short term out to end-2023 compared to its June predictions. But it slightly lowered the end point of its predictions for 2025 to 2% and below previous estimates. 

This suggests to us that the bank is not overly concerned about de-anchoring inflation expectation targets and sees its current actions being sufficient. Should the end point rise above 2%, the bank would presumably need to be doing much more, in our view.

 

Figure 1. Swiss CPI (year on year) and SNB inflation expectations

Source: Federal Statistics Office of Switzerland, SNB.

 

Importantly, there are nascent signs of weakness in Swiss inflation. The most recent Swiss CPI figures declined (figure 2). We believe these figures represent a potential first but meaningful challenge to the narrative of sticky inflation and could hint that inflation is already showing signs of dimming in Switzerland.

 

Figure 2. Swiss CPI (3m on 3m, seasonally adjusted and annualised)

Source: Federal Statistics Office of Switzerland.

 

What about the balance sheet?

We anticipate that the SNB will need to further tighten policy and expect more rate hikes ahead. Inflation developments are central to the bank’s actions and we see the currency providing crucial guidance. At the moment, we see the SNB reaching the peak speed of rate hikes and that increments greater than 75bps are unlikely going forward.

As it continues raising rates, we do not expect the SNB to increase the pace or size of rises from here. We see the Swiss terminal rate staying in relation to the Eurozone terminal rate, with European rates seen climbing to about 2.5% while Swiss rates stay 50-75bps through that level around 1.5-2% - this outlook is, of course, subject to fast-changing macro developments.

The SNB is willing to let the Swiss franc appreciate nominally, thereby naturally limiting imported inflation. It could go even further and in our opinion will also tolerate real appreciation. Though never explicitly stated as an order of priorities, the bank first ended negative rates and now could look at reducing its balance sheet.

 

The interplay between policy tools

How the SNB finds an equilibrium between hikes and balance sheet reduction is an art rather than a science, though a recent press interview from SNB President Thomas Jordan shed light on the bank’s thinking. Responding to a question about how the bank will use the balance sheet as an alternative to raising rates, he said the bank would require inflationary pressure, positive interest rates and a weak Swiss franc. Indeed, the bank is willing to fight potential inflation by letting the franc appreciate nominally and thereby tame imported inflation, but he clearly opened the door for the tightening to occur not just from higher interest rates, but also from reducing the balance sheet. In fact the SNB did sell francs in Q2, he said.

No less interesting was a statement regarding the neutral rate. Jordan said he does not see monetary policy being stimulative now, implying that the neutral rate has been reached.

Given these remarks and the fact that rates are clearly positive, we believe the SNB could accelerate its use of the balance sheet as a monetary policy tool. We see the bank seeking a balance between positive rates on the one hand but not too strong a Swiss franc on the other. Jordan’s comments also suggest that the SNB’s policy stance is already neutral. The bank may choose to diminish the use of rate hikes as a policy manoeuvre and instead rely more on being active in foreign exchange markets. Since the SNB will employ a risk-reward analysis when acting,  it may find that now that rates are positive, shrinking the balance sheet gains importance.

 

Growth in a global context

Echoing the worldwide fall in growth, the SNB shaved 50bps from its Swiss GDP forecast to 2% for this year. The bank cautioned that risks from a global economic downturn, a worsening of the gas shortage in Europe, a power shortage in Switzerland and resurgence of the Coronavirus pandemic created uncertainty in its forecast.

That said, while the short-term economic outlook in Switzerland has deteriorated, developments in the labour market are positive (figure 3). Generally, we also see the economy remaining resilient and the banking sector in a healthy state.

 

Figure 3. Swiss unemployment (seasonally adjusted)

Source: State Secretariat for Economic Affairs

 

As Switzerland is typically buffeted by global activity, we expect an interplay between the country’s fiscal reaction, the monetary reaction and developments in energy prices. Globally, as fiscal stimulus and energy support packages have shifted into high gear, monetary policy has needed to step up and become even more restrictive to counter the fiscal stimulus. This interplay means that a wide range of scenarios remains possible given the varying degrees of external shocks.

 

A canary in the coal mine

We see the most recent 75bps rise reflecting the SNB staying the course and sticking to its medium-term plan to meet inflation targets without reacting too much to market perceptions. It was among the first central banks to tackle inflation already in June with a surprise, chunky rate hike that preceded the European Central Bank (ECB) and acted like something of a canary in the coal mine on central banks waking to the persistence of inflation.

SNB communication has also been somewhat smoother than other central banks. We believe that central bank speak in today’s inflationary environment is more effective when it is less precise. Sticking to past techniques of detailed forward guidance is disconnected with today’s uncertain environment. As such, the SNB speaking perhaps less and in broader strokes guides the market sufficiently without adding a level of granularity that can age poorly in volatile markets and lead to backtracking on previous communications.

 

Attractive entry points

Looking ahead, we see more policy tightening in store for the SNB but believe the bank is currently at the peak speed of travel. The main questions remain how the currency will impact the way forward; and when and how the balance sheet will be used as a tool.

Current credit valuations have reached levels not seen in decades, with positive yields across the Swiss fixed income gamut of investment grade debt. Given our outlook for rates and the economy, we see current yield levels offering investors an attractive entry point.

 

Figure 4. Current Swiss yield levels offer attractive entry points

Source: Bloomberg. Yields as of 19 Sept 2022. Past performance is not a guarantee of future returns. Yields are subject to change and can vary over time.