Key Highlights

• ECB to start calling time on euro rally
• SNB vigilant, but franc intervention not imminent
• LatAm vs. APAC FX flow divergence unsustainable

European Central Bank (ECB) forced to pivot ahead of tariff risk, leaving euro strength excessive and misaligned

EXHIBIT #1: EURUSD VS. ECB Q2-Q4 EASING EXPECTATIONS 

_{Source: Bloomberg, BNY}

Our take

The ECB’s Q1 judgements on the economy are no longer valid. The key takeaway from the March meeting was “meaningfully less restrictive policy”. The Governing Council (GC) opted not to comment on the impact of tariffs due to insufficient information. The structural change in global trade is important for many Eurozone economies and we expect GC members to focus on downside risks to growth and inflation. The staff projections from March are also no longer valid. It would be beneficial for economic stakeholders if the ECB could provide preliminary analysis on the impact of tariffs on growth and inflation, similar to the Bank of Canada’s recent approach.

Forward look

We expect President Lagarde to signal ongoing easing and verbal pushback against euro strength in upcoming meetings. Even in the best-case scenario, growth expectations have been damaged. Eurozone data that captures changes in sentiment since April 2nd is limited. However, the data available (the ZEW survey), is already showing a sharp drop in sentiment. Monetary policy is back to restrictive. Equity valuations are sharply lower, credit spreads have widened and the euro is materially higher. These factors significantly offset lower sovereign bond yields and a widely expected cut in benchmark rates. The euro is now materially misaligned with rate expectations (Exhibit #1). While the ECB and Eurozone governments would welcome signs of reserve status for local assets, euro strength does not support their policy objectives. 

SNB not on the verge of intervention

EXHIBIT #2: SWISS NATIONAL BANK LIABILITIES

_{Source: OECD, BNY}

Our take

FX and fixed income markets continue looking to move away from dollar exposures, with the Swiss franc a top choice given its traditional haven status. As the currency surges to record highs on an effective exchange rate (EER) basis, markets are anticipating intervention from the Swiss National Bank (SNB). The SNB has maintained an easing bias. Support for the economy has a renewed urgency, as the U.S. administration is expected to announce tariffs on pharmaceutical imports on top of Switzerland’s currently suspended 31%-32% reciprocal tariff.

The Swiss Government stated that, “The chemicals and pharmaceuticals industry is Switzerland's leading exporter, generating roughly 50% of total annual exports and 7% of GDP”. Damage to this industry would severely impact Swiss balance of payments, considering the country runs a trade deficit without pharmaceutical exports. If the country moves towards a structural current account deficit, the franc’s safe haven status could be called into question.

Forward look

If the franc continues its current trajectory, the SNB will likely act quickly rather than waiting for the June decision. SNB President Schlegel has not ruled out a return to negative rates. Swiss Average Rate Overnight (SARON) futures indicate a 50% chance of SNB benchmark rates dropping to -0.25% at the September meeting, but the SNB could move sooner. This rate change is necessary before the SNB begins large-scale intervention, defined as at least CHF30bn per month (5% of the SNB’s balance sheet). Additionally, based on the 2011 sequencing, SNB liabilities need to fully convert to sight deposits first. Currently, 25% of such liabilities are in the form of SNB debt certificates and repo transactions, which can roll into sight deposits naturally.

Aside from early rate cuts, the clearest signal of imminent intervention by the SNB is advance redemption of debt certificates to increase sight deposits. Until such steps are taken, the SNB will likely allow the market to determine CHF rates, subject to smoothing operations. Unlike in 2011, establishing a minimum exchange rate against the euro is not an option.

APAC vs. LatAm flow diverging strongly, but not sustainably

EXHIBIT #3: APAC VS LATAM, MONTHLY SMOOTHED FLOW

^{Source: BNY Markets, iFlow}

Our take

In response to trade risks, the policy response of central banks in Emerging Markets is largely dependent on current account status. Even if a country can reach a negotiated settlement with the U.S., the impact on economic and trade certainty would be difficult to undo and require large-scale easing. As the market shifts towards “risk-off”, demand for yields has given way to demand for savings and valuations safety, which has benefited APAC FX flow. In contrast, high-yielding deficit currencies are struggling. LatAm is strongly underperforming as commodity-intensive economies face weaker terms of trade as global growth declines.

Forward look

The divergence in flow between APAC and LatAm FX is not sustainable. APAC central banks will push back against currency strength due to deflation risk. Latin American economies, especially commodity producers, are less affected by goods-based tariffs. Valuations are attractive and as gold’s current performance indicates, the market is looking for some degree of real asset protection, which commodity-linked currencies can provide. Latin American agricultural producers stand to benefit from any pivot by Chinaaway from U.S. imports. Our data shows that due to unique trade linkages, APAC and LatAm FX flow are usually well-coupled. Except for MXN, the latter group will likely see inflows as new terms of trade equilibria are established.

Bottom Line

Many G10 currencies, especially EUR and CHF, have benefitted from diversification flow due to recent events. However, we expect strong pushback from central banks due to disinflation or deflation risk, but extreme action such as intervention is not in the cards yet. EM FX remains in flux, APAC FX is not in a position to allow currency strength, and LatAm FX may have value emerge soon.