Why the Swiss National Bank can’t hike by less than 75bp this week?

It is almost certain that the US Federal Reserve (Fed) will deliver the third 75 basis point hike when it meets this week. Should the Swiss National Bank (SNB) follow with a similar rate hike?

It certainly does!

The Fed is set to deliver the third consecutive 75bp hike this week.

More importantly, the US policymakers will certainly emphasize the need to carry on sustained rate hikes to tame US inflation — which remains sticky near the four-decade high levels.

Fed has no choice but to sound hawkish

Last week’s US consumer and producer inflation data came as a sour reminder that inflationary pressures do not ease as much as the Fed would like them to.

Yes, the headline CPI and PPI figures fell for the second consecutive month in August, but the underlying factors told a less promising story.

The US core inflation — which filters out the impact of volatile food and energy prices — strengthened both for consumers and producers in August, suggesting that the softer headline figures could be mainly explained by cheaper energy prices over the month.

Indeed, the US gasoline prices have been easing since their June peak, when the price of a gallon spiked above $5. The price tanked by 20% only during August.

But the problem with energy prices is that… they are very volatile. And more importantly, the risks remain tilted to the upside, given the war in Ukraine, the tight global supply, and OPEC’s readiness to cut output to maintain prices at relatively high levels.

Fed Chair Jerome Powell said clearly at this year’s Jackson Hole speech that the Fed cannot rely on softer energy prices to declare victory on inflation.

This time, he is right. Higher rents, firmer food prices and more expensive medical care are now responsible for high price inflation in the US and warn that the US inflation may not have peaked just yet.

What does it mean for the Fed? More needs to be done to tame inflation.

But don’t expect the world to crumble on Fed decision

However, the expectation of a more aggressive Fed policy is fully priced, and perhaps overpriced.

At the wake of last week’s inflation data, activity on Fed funds futures priced up to 35% chance of a 100bp at this week’s FOMC meeting.

It is, of course, possible for the Fed to accelerate the pace of interest rate hikes and to announce a 100bp hike this week.

But the Fed has nothing to gain by surprising the market with a bigger-than-expected hike this week. Therefore, the base case scenario is still a 75bp hike.

And because the Fed hawks may have gone ahead of themselves, we could see the US dollar give back a part of the recent gains, the US yields retreat, and the equity valuations improve following this week’s Fed decision.

Yet, the size of an eventual relief, or whether we would see a relief or not will also depend on the economic projections and the dot plot — which plots how the FOMC members see the rates evolve in the coming months and years.

If there is any hint that the Fed members move away from the idea of ‘soft landing’, the Fed doves would be more aggressively back, and we could see a bigger relief across risk assets, whereas if Jerome Powell insists on the fact that the US economy and the jobs market remain resilient to the policy tightening, it would be taken as a sign that the Fed will carry on with sustained rate hikes, and the relief — if any — would be much smaller.

The second scenario is more likely to happen at this stage. We will see what the dot plot tells.

The so-called ‘dot plot’ will certainly show a higher terminal rate for 2023. It is expected to move to 4.2% from 3.8% plotted in June.

What should the Swiss National Bank do, then?

When it unexpectedly hiked its policy rate by 50 basis point in June, the Swiss National Bank (SNB) hinted that there would be another 50bp hike on the pipeline for September meeting.

But times have changed since then.

Since the start of 2022, more than forty central banks around the globe opted for a 75bp hike in once, including the European Central Bank (ECB).

The 75bp is the new 50bp.

If the SNB sticks to an outdated plan and hikes by 50bp, the tightening won’t have the desired effect on inflation — which advanced to 3.5% in August, the highest level since 1993.

Why?

Let’s be honest: whatever the SNB does, it will have a limited influence on inflation.

Inflation in Europe is mostly caused by abnormally high energy and food prices. And the common denominator between high energy and food prices is the war in Ukraine.

The SNB can’t stop the war, it can’t restore the energy supplies, and it can’t pull energy prices lower.

What it can do however, is to neutralize the impact of the strong US dollar and cool down the inflationary pressures in Switzerland, by making the energy imports cheaper thanks to a strong franc.

In this context, if the SNB opts for a 50bp hike this week, it would send a dovish message to the markets; the Swiss franc would soften, energy imports — negotiated in USD terms — would become costlier, and inflation would rise.

Therefore, the SNB should deliver a 75bp hike, parallel to its peers, if it wants to stay ahead of its fight against inflation — even if it means a further selling pressure on the Swiss stock and bond markets.

But the SNB doesn’t like the strong franc…

Yes, the SNB doesn’t like the strong franc, because the strong franc has a negative impact on Swiss exports.

But the SNB likes inflation even less. In the long-run perspective, there is nothing more toxic than high inflation for an economy.

Therefore, if the Swiss policymakers must choose between fighting against a strong franc, or against high inflation, they would choose to fight against high inflation.

The increased selloff in EURCHF is the collateral damage that the SNB could manage by FX interventions.

While we do not rule out the possibility of FX intervention by the SNB to throw a floor under the euro-swissy FX rate, we believe that such move is premature, and is not the SNB’s top priority right now.

What about the Swiss stocks?

Unfortunately, the hawkish SNB would mean a further selling pressure on the Swiss stock and bond markets.

We have seen that the summer rally in SMI was rather timid due to the strong franc. While the S&P500 rebounded close to 20%, gains in SMI remained well below, around 8.5%, because most of the SMI companies’ revenues come from outside Switzerland, and they are worth less in terms of Swiss francs when the franc appreciates.

The banks are relatively better placed than the rest of the economy to benefit from rising interest rates, as higher rates increase banks’ low-risk interest revenues. However, the rising mortgage and credit rates, and slowing economic activity hint that the Swiss bank revenues may take a hit, as well.

In this context, the Swiss banks outperform the SMI index, but they will unlikely post absolute returns as the SNB pushes its policy rate higher.