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February 4, 2015

How Crazy Will EURCHF Go?

The Euro CHF has crossed well over the 1.05 level and looks fairly solid to me. This is a huge bounce from the chaotic levels reached on 1/15 when the SNB floated (low of ~.85). The cross is now 20% off the bottom, and only 15% from where the craziness started.
Step back and look at the post chaos trading and you might conclude that the “market” is trying to reprice the EURCHF to some reasonable level. And that conclusion would be completely wrong. The market is not repricing the CHF – THE SNB IS INTERVENING – What you have as a price today is just a dirty float managed by the SNB.  There is no price discovery  – the FX market is being led by the nose.

I’ve been looking at this picture and trying to figure how this will play out. I see three possible scenarios:   
1) For the immediate future (a couple of months maybe?) the SNB will prevail and the trading range for the EURCHF is 1.05 on the bottom and possibly as high as 1.10. The actual rate is up to the SNB. The markets might try to goose the cross up for a bit (the carry trade using short CHF as the “wheel” is compelling).   
2) At some point this year the market calls the SNB’s bluff. We get back down to 1.05 and the SNB is forced intodefensive intervention (trying to hold a line in the sand). This, of course, can’t work for long. The SNB has shown it’s hand, the market understands that the SNB is weak and will back off if forced to. This outcome takes us to below par fairly quickly.   
3) Something unbelievable happens. Something that is not on anyone’s radar today. Because this outcome is unanticipated it has significant knock-on consequences to global markets. The result is a significant turn around in the Swiss/EU inflation picture. Actual monthly inflation numbers and (more importantly) inflation expectations rise quickly. A huge turn around in the global bond markets follow – lights start turning off all over the place. Gold comes back as a safe haven.   
Basically, #3 is a Black Swan event. Something that is so remote, that it’s probably not worth considering. But if it were to happen it becomes a game changer.   
My #3: THE EURCHF TRADES to 1.50!!!   
Ok, that’s crazy you say. And on balance I would agree. It’s much more likely that some version of my #s 1 and 2 play out. What are the odds that #3 is the outcome? 10%?.. 5%? Some things that lean me to conclude that the answer is not “Zero Percent”.   
- In December the SNB took in another $35B of hot money trying to defend the 1.2 Peg. There are no numbers out yet for what the SNB had to shell out in January before the breach of 1.20. I talk to folks who have better insight than me and they conclude it was at least CHF 2B a day. Then there is the unknown intervention that has taken place since January 15.  
Put this together and you have the non gold portion of the SNB’s reserves NORTH of $400B!. Some of this is foreign central bank reserves – a significant portion is long and short term safe haven plays. That huge amount is now on the SNB’s balance sheet. It is an incredibility large amount of hot money.   
- I hear many voices in the the FX markets saying :”Fuck the CHF and the SNB!” “Those bastards lied to us – I’ll never trust them again!”  Does this mean anything? NO, but it’s a very odd sentiment for a reserve currency to have. Maybe it will pass with time. If it lingers, the probabilities of my #3 go up.   
- Swiss bonds have negative yields out to fifteen years. I ask, “When’s the crash?” Which global bond fund manager is going to pile into this? The flip side is that with the curve in negative territory every CHF bond in the world is trading at a HUGE premium. Remember the investment axiom “Sell High”. It can’t get much higher than this for these bonds. Sell em all, and move onto something that has a carry, not a negative coupon.   
- Swiss stocks? If you had in your models my numbers #1 or 2 you would have to conclude that many Swiss equities are fully priced. Where are the sales and earnings going to come from? Exports? Domestic demand in a deflationary environment?  The global stock pickers will be under weighting Swiss stocks in favor of other places.  
- You have a huge FX market that has rarely done big prop trading plays against the CHF in the past decade. As of today (actually a week ago) the prop traders all have a brand new best friend – the SNB. You get paid very well (through the swaps market) to be short the CHF – all traders love to get paid to play. If the FX market decided it wanted to lean on the CHF (with the wind of the SNB behind their backs) it could result in a $100b shift in net supply and demand. That by itself would get us back to 1.20.   
- The CHF story is partly a hot money story. That has changed significantly the past few years. The door for the USA Black Money is totally closed. It’s not too different for EU “names”. Swiss banks no longer provide anonymity.  The Swiss banks charge 2Xs other money centers for financial services. Without “Secrecy” there is no incentive to park cash in francs.   
- The Peg was a mistake from the get-go. In 2011 the SNB was under speculative attack. It could then have created a dirty float as it has today. Instead, it chose an artificial line in the sand at 1.20. From the very first day the question was “How long will this last?”  This was a stupid policy that took all other choices out of the SNB’s hands. Thomas Jordan said recent: “It was always temporary”.  Because markets do what what they do (perverse but true) it was natural for market forces to bring about a showdown. Money (largely from spec players) came pouring into Switzerland BECAUSE of the peg. There is no more line in the sand for the market to test. I know this may sound crazy, but the absence of the peg can clear the market so that it can trade “two ways”.   
- Who would love, love, love a EURCHF 1.5 print? That would be the boys at the SNB. If that happened they could strut down the Bahnhofstrasse with their chests pushed out. They could make fiery speeches at the Swiss Parliament. Jordon could do an interview with Peter Fischer at NZZ and say:  
“We were right along along. We now have inflation above 2%, interest rates have normalized. The CHF has returned to the level that we always said was purchasing power parity. And, of course, everyone should be very happy with the $200B of gains that the SNB has enjoyed!”

- Could EURCHF go back to where it was six years ago? Stranger things have happened of late – look at crude. The EURCHF was as high as 1.68. Just saying…..   
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- Did I mention that many people have a “hate” thing going on with the CHF/SNB? Crazy….but not to be ignored; sentiment always trumps logic.   
So what does the world look like if my #3 comes to pass? Ah…A 1.50 EURCHF would mean EURUSD is SOUTH of par by a fair bit. If the EURUSD gets that cheap, then you’re talking USDJPY NORTH of 140.   
That outcome would create inflation in Japan and the EU. It would turn their bond markets from negative to positive and it would change inflation expectations. On the other hand, the US would be facing very big deflationary forces. Nominal growth would fall to real growth (if any). An outlook like that would cause future deficits to explode in real terms. Without inflation higher than 2% (devalues the debt and makes it ‘payable’) the US fiscal picture gets out of control – fast.   
This #3 is a long-shot bet. I would handicap it at 5%. But if we find that the EURCHF makes a break to 1.10 then those odds fall pretty fast. Still a long shot. If money parked in Switzerland decides to vote with its feet, then even 1.20 is not so crazy. At that point everything will be upside down. The odds of EURCHF1.50 go to 50-50, and all hell breaks lose.  
 About The Author - Bruce Krasting had worked on Wall Street for 25 years--"For 25 years I woke up thinking, "What am I going to do today to make some money in the market". I don't do that any longer. But I miss it." Nowadays, Bruce blogs about his take on financial events at Bruce Krasting(EconMatters author archive here.)   
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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