CHF To Finally Turn A Corner And Head Lower

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Includes: FXE, FXF
by: D. H. Taylor

Summary

Interest rate differentials favor main EU government debt versus Switzerland.

Economic data show that while the EU is improving Switzerland's data is far less rosy.

ECB is likely to remove its policy accommodation long before SNB removes its negative interest rate program.

Last week EUR jumped up significantly higher versus most other currencies. There is one currency in particular that this may be the beginning of an extremely long and large move higher. During the financial crisis, EURCHF moved downward more than 8,500 pips in fairly short order as money rushed out of Europe and into the perceived relative safety of the tiny bank haven in the mountains, Switzerland. The fundamentals are now beginning to favor EUR of CHF. The ultra-low interest rate environment in Switzerland will compel Europeans to move their funds out of Switzerland and back into the common EU. CHF will finally, at long last, start to ease lower.

As the chart shows, the move lower in CHF was dramatic. To point out for the FX non-savvy, the move from 1.8500 to 1.0000 is 8,500 pips. That is massive. On a daily basis the currency moves about 40 pips. The move was so problematic that the Swiss National Bank undertook multiple agendas to stem the move higher in CHF. First, the bank pushed for ultra-low interest rates sending their government bond rate below zero percent. Second they put a line in the sand as to where they would ultimately allow their currency to fall to of 1.2000 (despite having already visited that Level in mid - late 2011). However, on one bright and early winner morning in 2015 the SNB decided to change its mind and no longer defend that particular level. The result was a one-day move lower of some nearly 2,500 pips.

The bank is still defending its currency from large moves higher. However, they are no longer defending a specific level, i.e. the 1.2000 level. The SNB steps in regularly buying multiple currencies versus its own currency, weakening the CHF. By doing this they have amassed a virtual fortune of currency reserves:

The economic and geopolitical landscape in Europe is changing. The French presidential election has made a lot of investors queasy as voters were deciding the first round of the election. There was not enough certainty that Macron would win. Instead, ultra-right and left wingers were edging closer to potentially moving to the next round. The past few months saw even more money move out of the main EU and into the more safe-haven currency of Switzerland.

When Macron won the position to advance to the second round, EUR jumped up higher. In every poll, Macron handily defeats Le Pen. The EU is safe from a referendum from France:

At the same time the election is keeping the ECB from announcing what the markets are suspecting all along: The European economy is improving and the risks for deflation and economic stability have moved towards neutral. The ECB will be able to let off the gas from the bond buying, or, Quantitative Easing (QE). With the absence of an 800 pound gorilla in the room buying up debt instruments, interest rates are more likely to drift higher. Here is a chart on the differential on interest rates between the EU stability fund and Switzerland's government bond rate:

Right now, the EU stability fund versus the Swiss government bond yields are -0.42% versus -0.12%, respectively. If the European bond rates start to move higher, while simultaneously the Swiss remains unchanged the differential will narrow bringing a feast for the carry traders. As it is right now, the carry trade clearly favors Switzerland over Europe. But, the prospects of no more QE out of Europe while a continued negative interest rate environment in Switzerland will bring money out of the safe-haven nation into the main EU. The pathway for that to happen is buying EUR over CHF.

However, in Germany, government interest rate s are already favoring those of the in-kind government bond rates coming out of Switzerland:

That in itself will draw funds into Germany and out of Switzerland via a carry trade.

Despite Europe's improved prospects, the economic data in Switzerland is not so bright and rosy. GDP growth rates are paltry. Swiss GDP versus EU GDP is 0.1% versus 0.6%, year-over-year, respectively.

Inflation tells a slightly better story. Swiss inflation is 0.6% versus European inflation which is now at 1.9%:

In general, with improving economic activity in Europe the ECB will start easing back on QE. Right now the ECB is purchasing some €60 billion in assets every month, this amount, down from the initial €80 billion a month. My expectation is that at the next meeting the ECB will sound a more hawkish tone. The French election will be out of the way so there will not be any obstacles that the ECB will want to avoid affecting. If the economic indicators continue to improve and inflation moves higher then the impetus for that change in asset purchases will be a bit stronger.

At the same time, the Swiss economic data is far too anemic to propel the SNB to remove its policy accommodation any time soon. Therefore the potential of increased interest rates in the main EU over the counterpart interest rates in Switzerland will greatly favor Europe.

I do not expect a one-way move in EURCHF. This will take a significant amount of time for the currency to move upwards. Because of that I am going to be trading in a specific way. I am selling EURCHF puts, out of the money with about a .25 delta and 60-days to expired. I will roll on the trade meaning I am not going to put in 100% of the size I want to hold all at once. Instead, I am going to add some new positions every two weeks over the course of a two month period.

Disclosure: I am/we are short CHF, CHFS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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