During the last two months of 2010, the Swiss franc (CHF) appreciated 4.5% against the U.S. dollar and 8.5% against the euro. Overall, the broader CHF index has risen approximately 7%. This strength is surprising as the CHF is generally considered a safe haven. Usually the Swiss currency gains when uncertainty and panic reign in financial markets and when asset prices are falling. As investors’ sentiment has become very bullish and asset prices are increasing, the CHF is therefore not supposed to strengthen.
This means either the increase in CHF is a harbinger of worse things to come (intelligent investors are already seeking a safe haven) or the CHF has become more popular due to other underlying factors.
Traditional "pull factors" that make currencies more popular (rising yields and/or a tighter monetary policy) don’t apply to CHF:
The Swiss market performs poorly compared to the DAX, the U.S. and Asian equity indices, while the 10-yr Swiss benchmark government bond yield just 1.7% and 3-month CHF LIBOR (London Interbank Offered Rate) is even lower than 3-month Japanese yen (JPY) LIBOR. In other words, there is not much yield to chase in the Swiss market.
A tighter monetary policy would come as a surprise. The Swiss National Bank (SNB) has lowered its inflation projections for the years to come, while a stronger currency is in itself already a form of monetary tightening. Indeed, the SNB might even consider additional currency interventions in the future to prevent an increasing franc from hurting the open and export dependent Swiss economy too much. The prospects for a pick up in short term rates in the near future, therefore, are slim, even while the economy is improving thanks to a booming German economy and an improving financial industry (Switzerland has a relatively large financial service sector).
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The most important reasons why the Swiss currency are strengthening are therefore "push factors" or non-traditional "pull factors." To begin with the latter, investors are increasingly attracted to currencies that are backed by stable government finances. Switzerland has a long tradition of low inflation and low government deficits and debt. There is a very slim change that the government will deliberately seek to debase its currency in order to lower the real "value" of its current debt or to end up in a default.
The other major currencies don’t share these sound fundamentals. Government debts in Japan and in many European countries are likely to be too high to be fully repaid in current euros or yens, taking into account the costs of an aging society and – in Europe – an already high and growth limiting tax base. Either the chance of default is high, as in the PIIGS countries, or a refugee to higher inflation is more likely, as the Japanese authorities are aiming for. This is also true for the U.S., where the Fed explicitly said to aim for a higher inflation rate. This is sound monetary policy in order to escape a deflationary spiral, but also sets the stage for an "out-of-control" inflationary spiral given the large amount of extra-created dollars pumped into the economy and the political resistance to tighten monetary policy on time.
These (long term) risks have big investors rethinking their portfolio allocation. For example, more are investing in the emerging markets, which boosts growth prospects and often induces more sound government finances. Secondly, central banks with the biggest foreign currency reserves, like China, are openly discussing the need to diversify their holdings, which are currently predominantly in dollars and to a lesser extent in euros. The CHF, as a widely traded and liquid currency, profits from these "anything-but-the-euro-and-dollar-flows." For investors who seek to have exposure in Europe but wish to avoid the euro, the CHF has much appeal. In other words, the CHF becomes more and more the anti-euro.
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As the problems in the weaker European countries are far from over (the spreads between Spanish, Italian, Portuguese government bonds and the benchmark German government bonds remain worryingly high) it is tempting to become even more bullish on CHF.
Vis-à-vis the euro it might be profitable to go long CHF in anticipation of elevated tensions in the eurozone. However, against the dollar the CHF could start to weaken. The reason is that the SNB manages an economy, which is "too small" given the importance of the CHF in world markets. When CHF remains in demand thanks to "anything-but-the-euro-and-dollar-flows," the Swiss currency will appreciate more than the economic fundamentals justify, damaging the important export sector. This increases the probability that the SNB will intervene.
As a result, short-term CHF interest rates will remain under downward pressure and could decline even more to the low range of the SNB target band (0% - 0,75%). On the other hand, real interest rates in the U.S. are under upward pressure and expectations of a tighter monetary policy by the Fed are slowly rising. In case there is no other round of panic and sharply declining prices of risky assets, the upward pressure on USD/CHF could, sooner rather than later, gain the upper hand.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
