SNB Surprises, The Fed Stays Course

The Swiss National Bank surprised the market by announced a negative 25 bp rate on sight deposits and lowered the 3-month Libor range to -0.75% to 0.25%. Although SNB President Jordan revealed that it was inflows from Russia that compelled it to intervene in recent days, the fact of the matter is that the negative rate goes into effect the same day as the ECB's next meeting, January 22.

The announcement took the market by surprise. The SNB had given no clue at last week's quarterly review. The euro immediately shot up to CHF1.21 from just above the floor of CHF1.20. Nearly as quickly, the gains were retraced leaving the euro near CHF1.2040.

The SNB's move to negative interest rates is a bit different than the ECB's. The ECB's adoption of negative interest rates was to discourage member banks from hoarding liquidity. It was to induce them to lend to each other and to businesses and households. In contrast, the SNB's move is aimed at at foreign banks to deter using the franc as a safe haven. The effect on Swiss banks may be marginal as the SNB announced an exemption threshold of 20 times the minimum reserve requirement.

Of course, the SNB's move will fan expectations that the ECB will widen the assets it is buying at its January meeting. The market had been moving in this direction. Making the market cautious, however, are three things. First is the opposition within the executive board and Germany is not alone in its opposition. Second, the European Court of Justice makes a preliminary and non-binding decision on January 14. Third, Greece may be in the middle of an election campaign and the leading party wants the ECB and other official creditors to give more debt relief, which makes buying sovereign bonds, or Greek bonds at any rate, more troubling.

The second consecutive monthly increase in the German IFO dovetails nicely with the ZEW and the improved orders data. With monetary policy that was exceptionally easy for Germany, the weakness in the euro and the drop in energy prices is a potent stimulus. The challenge Germany faces stems from the lack of reform in its services and the weakness of its export markets, including China and Russia.

The improvement in German confidence was not nearly as surprising as the strength of UK retail sales. They jumped 1.6% in November, four times stronger than the Bloomberg consensus, and the October series was revised to show a 1% gain rather than 0.8%. The year-over-year pace rose to 6.4% from a revised 4.6% in October, which is the strongest in a decade. There was clearly a "Black Friday" impact. Department store sales rose 15.5%, led by electric appliances sales at 32%. There was heavy discounting and the retail sales deflator was -2.0%, the most in a dozen years.

Despite the downside risks to UK inflation, the strength of retail sales and the fact that this is the first time that wages are above the rate of inflation since 2009, may see another MPC member join the hawkish dissent in Q1 next year. Sterling, which had set a new marginal low for the year yesterday is rebounding today. The $1.5660-80 area needs to be overcome to signal a return to $1.5800. In the strong US dollar environment, sterling is more attractive on the crosses than against the greenback.

Our heuristic approach to the Federal Reserve is that the policy thrust emanates from the core leadership which presently is Yellen, Fischer and Dudley. What follows from that simple observation is that the FOMC statement is the clearest expression of policy. The forecasts (dot plot) and the minutes from the meeting dilute and distort that policy signal.

This is especially relevant now. There is a rotation of regional presidents with voting authority next year. Moreover, all three of the dissenting presidents (three of the five) have reportedly signaled plans to leave the Fed.

There were four notable changes in the FOMC statement:

1. As widely expected the Fed dropped the "considerable time" forward guidance and replaced it with the idea that it can be "patient", which Yellen later suggested was for at least the next two meetings, which essentially pre-commits the Fed, ruling out a rate hike in Q1 2015.

2. The Fed upgraded its assessment of the labor market. No longer are labor resources "significantly" under-utilized.

3. The Fed drew attention to the fact that surveys of inflation expectations have been fairly stable, while market-based measures have fallen.

4. The statement reintroduced the "monitor inflation developments closely." Yellen was quite clear at the press conference and repeated several times the statement's assessment that the impact of oil prices on inflation was transitory. She seemed prepared for some of the downside risk of inflation materializing in the near-term.

We continue to see the most likely scenario for the first rate hike in June. We acknowledge some risk that the hike is delivered in September instead. Barring a significant surprise, the choice between the two meetings will be data-driven.