Euro Falling: Swiss Speech Equals Forex Volatility

08/28/2008 12:00 am EST

Focus: FOREX

On Wednesday, August 27, Swiss National Bank vice chairman Philip Hildebrand delivers a late day (for Europe) speech at the Zurich Stock Exchange titled "Lessons from the Financial Market Turbulence." Savvy traders will want to take note of the speech, as it could have larger implications within the forex markets. Foremost, it's pretty rare that a Euro zone late day speech happens to coincide with US market hours, but once in a while, they just line up.

Here's the thing: Swiss National Bank governing board vice chairman Philip Hildebrand has been a governing board member since 2003, with his tenure set to expire in 2009. Really, there could be something larger brewing here.

In a speech given in New Orleans to the annual meeting of the Allied Social Science Associations on January 5, 2008, Hildebrand said:

"...second finding concerns the extent to which longer-term inflation expectations react to fluctuations in actual inflation, and this provides further insight into how well the central bank's objective is incorporated into the expectations of market participants and the public. Recent studies have shown that longer-term inflation expectations in the euro area are decoupled from developments in actual inflation and do not respond at all to macroeconomic news, further pointing to the solid anchoring of expectations in the euro area."

"Moreover, there is considerable empirical evidence indicating that the short-term predictability of the ECB's monetary policy - namely the ability of financial market participants to correctly anticipate the next monetary policy decision - has increased over time. For example, it has been found that, out of a total of 142 days on which Governing Council meetings were held from 1999 to December 2007, financial markets were surprised - according to a common definition of the surprise element in this literature - on only eight occasions. Furthermore, the biggest surprises occurred in the first three years of Economic and Monetary Union, indicating that the short-term predictability of the ECB has increased over time. This evidence may reflect the fact that financial markets have gradually learned about the ECB's monetary policy framework and communication."

Here's the kicker though: In his conclusion, he said, "One communication challenge for the ECB concerns the apparent divergence between actual inflation and that perceived by the public in a number of euro area countries. Although this divergence has declined over time, it is important to deepen our understanding and to address the causes of the apparent misperceptions in order to maintain and strengthen the confidence of the euro area public in the single European currency."

The issue here is that we must stop and ask ourselves how to bridge the gap of "concerns the apparent divergence between actual inflation and that perceived by the public."

The fact of the matter is that while short-term inflation is an issue, the public knows that by artificially propping up the euro, the situation isn't good for the economy. Have I mentioned that the ECB really goofed in its interest rate policy over the past year? However, it is likely that Hildebrand may not be so hawkish, and that his speech on Wednesday may actually diverge from that of the ECB's tone over 2008.

There's even more to the story though. Swiss National Bank chairman Jean-Pierre Roth said in the June half-year update, "Although the Swiss economy has also grown at a slower pace, the SNB has not changed its forecast of real GDP growth of between 1.5% and 2% for 2008."

"However, it has increased its inflation forecast and is now expecting an average rate of 2.7% in 2008. Nevertheless, assuming that the Libor remains unchanged at 2.75%, inflation should edge back down to 1.7% in 2009 and 1.3% in 2010, as a result of the expected economic downturn."

"Considerable risks are attached to this inflation forecast. Stronger price increases are likely, should energy prices rise again or the Swiss franc depreciate on the foreign exchange market. A more significant slowdown in the global economy might ease inflationary pressure.

"Given these conditions, the SNB is maintaining its cautious stance and leaving its monetary policy strategy unchanged. In view of the medium-term inflation outlook, it can afford to do so. After all, there is enough reason to suggest that the current inflationary trend is of a transitory nature."

Clearly, the Swiss National Bank knew in June that it would be just downright dumb to raise interest rates, even with the cautious inflationary outlook, as the event could be the final nail in 2008 GDP growth. The ECB, on the other hand, not so much.

It's my personal opinion that Trichet and company have really erred over the past few years, and the overly hawkish stance by the ECB (and the July rate hike to 4.25%) has clipped liquidity.

Really, we could be on the eve of a mutiny at the ECB, and speeches like Hildebrand's on Wednesday could be the starting point.

At the end of the day, I expect some semblance of frustration to surface on Wednesday regarding the ECB's over-attention to short-term inflation.

Worrying about inflation is smart, but worrying about inflation so much that you kill GDP growth by credulously retracting liquidity when it's needed most is just downright silly.

The paradigm shift has begun.