After a whole year of safe haven assets getting de-havened (most notably gold and the Japanese yen), the Swiss franc (FXF) has remained remarkably strong. I believe the current turbulence in the emerging markets presents an opportunity to short the franc at an attractive price.
The best stop loss ever
The Swiss National Bank (SNB hereafter) is Switzerland's central bank and capped the currency to the euro at the minimum rate of 1 euro=1.2 CHF (Swiss franc). Which means if the EUR/CHF falls below 1.2, the SNB will sell an unlimited amount of francs to make sure the EURCHF stays at least at 1.2.
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As I see it, this is a nirvana situation for speculators. When have you ever had a trade which you know the exact price you can get out of? Theoretically stop losses should work, but a stock could gap down 20% and Fukushima caused a huge ripple even in forex ( widely believed to be the most liquid market). But if you're long the EURCHF, 1.2 is a solid lower barrier. At the current 1.2230 exchange rate, it's only a 2% loss max. Next, I'll explain why I believe it to be solid.
The rock steady barrier
The SNB has reiterated again and again and again for years its resolve to keep the cap in existence. There appears to be little doubt it will continue repeating this line in at least the next few months. There is little to no international complaint about the barrier. This means it can stay in place for the foreseeable future with no opposition from the rest of the world.
The canary in the franc mine
Some might question the SNB's resolve. If demand for the franc surges during a crisis (like we're seeing in the emerging markets now), won't it be possible that the EURCHF falls below 1.2? Couldn't a speculative attack form, like how George Soros broke the Bank of England?
First of all, there are significant differences between what the BoE faced in 1992 and what the SNB is doing now. The BoE was propping up the pound-dollar exchange rate by selling dollars it owned and buying pounds. It had a finite amount of dollars at its disposal, so it was open to a speculative attack. However, the SNB can sell an unlimited amount of CHF, to keep the EURCHF above 1.2.
Second of all, even if huge amounts of capital are flooding into the CHF, we can gauge this by looking at the SNB's forex reserves. This gives us a heads-up on whether the EURCHF might be near breaking point. Perhaps if keeping the EURCHF above 1.2 requires the SNB to print so many CHF it creates a distortion domestically, it might give up and retreat.
The SNB's forex reserve has not changed much in over a year, peaking at 485 billion in 2012 (this includes gold) during the depths of the euro crisis. Thus, so far capital has not flooded into the CHF. EURCHF is nowhere near breaking point.
Why this may be a Great Opportunity
Just because the downside is limited on the EURCHF, doesn't automatically make it a great trade. The other great thing about this trade is the huge potential upside and the lack of any expectations from the market.
The SNB's Dilemma
The SNB faces a big dilemma when it comes to monetary policy: on the one hand, monetary policy is already very accommodative but the currency remains overvalued (or so it states).
It is difficult to determine whether a currency is overvalued or not, but the Swiss franc remains the currency that has not seen much of a normalization. A detailed analysis of the economy would have to await another article.
On the other hand, the domestic real estate market is overheated and it has taken action to curb the mortgage market.
The Swiss National Bank, with the backing of the Swiss government, will now require the country's mortgage lenders to hold an additional 2% of mortgage-related risk weighted assets to underpin their lending, up from the 1% imposed in February 2013."The SNB has concluded the sustained strong increase in mortgage loans and the prices of Swiss residential properties has caused the imbalances to become even greater in the current low interest-rate environment." -The Swiss Federal cabinet
The franc rallied on this move, which appears to be tightening liquidity.
Thus the dilemma Swiss authorities face: they view domestic excess liquidity as a problem. They also see the overvalued currency as a problem. Domestic excess liquidity is not helping the currency become better valued. The CHF just sits there doing nothing.
The opportunity lies in the possibility of SNB reaching the conclusion that the Swiss Franc's value has little to do with monetary policy and more to do with perceptions. If the SNB can foster expectations of a devaluing franc, then it can tighten credit domestically while devaluing the currency. And what's the best way to foster devaluation expectations? Start by hinting at going Japan and then maybe raise the EURCHF cap to 1.25 while suggesting further increases. Sounds unorthodox, but so are the Fed's QEinfinity, the Bank of Japan's QQE and the ECB's QE-that-never-comes.
Of course, this is very speculative and may take years to play out, but the carry costs of holding long EUR/CHF are near 0, the downside is 2% and a potential reversion to pre-2008 crisis levels at above 1.5 would be a 20% bonanza. So for speculators with a long-term horizon, this might be a trade worth considering.
Additional disclosure: May go long EURCHF in the 1.21XX if money rushes into the Swiss Franc on further emerging market selling