Is The Yen Or Swiss Franc A Better Funding Currency?

Aug. 16, 2017 11:27 AM ETFXE, EUO, FXY, YCS, FXF, ERO-OLD, JYNFF, DRR, ULE, YCL, EUFX, URR3 Comments
Marc Chandler profile picture
Marc Chandler
15.13K Followers

Summary

  • Yen and Swiss franc are funding currencies.
  • This goes a long way to explaining why they rally on heightened anxiety.
  • The Swiss have lower rates than Japan and the franc is less volatile than the yen, but technicals argue for caution.

Retail investors and some institutional investors focus on the asset they want to acquire in anticipation of price appreciation. The game for some institutional investors is more complicated. It is not only about the asset that is to be purchased, but it is also about how the purchase is funded. A low returning asset is a drag, but if the funding costs can be reduced, a low returning asset may still be attractive.

In the capital markets, securing cheap funding is accomplished by selling a low yielding (and ideally a low volatility) instrument and using the proceeds to purchase a higher yielding or a better performing asset. In the foreign exchange market, the dollar is the ultimate funding currency. Americans are the marginal buyer of global equities. They sell dollars and buy foreign equities, and largely on an unhedged basis. Foreign companies and countries borrow dollars and frequently convert the proceeds back to their own currency.

Levered accounts often use the Japanese yen and/or Swiss franc as funding currencies. That is to say, those currencies are borrowed and then sold to buy another asset that is expected generate a higher yield than being paid for the funding. In times of heightened anxiety or a spike in volatility, the trade is unwound, which is to say that the purchased asset is liquidated and the funding is replaced (bought back). That is precisely what appears to have happened last week as the bellicose rhetoric over North Korea escalated. And it was the yen and franc's weakness before the weekend, which we saw as a tell that the market's focus was going to shift away from the Korea story.

If the geopolitical anxiety is easing, and the chances that Draghi breaks new ground at Jackson Hole next week, is it a safe time to look at the funding currencies, and if so, which looks better? To be sure, when a low yielding instrument is sold for an asset that is expected to offer a higher return, it is often called a carry trade. A carry trade is a trade in which one is expected to profit from the interest rate differential. That is the carry.

However, it is often poorly understood. Consider that currently, one can borrow yen for about -3 bps annualized for three months. That yen can then be sold, and dollars bought and put in a three-month time deposit and earn about 130 bps annualized for the three months. One earns 133 bps over the three months adjusted for the change in the value of the yen over that period. Over the past three months, the yen has gained 2% (not annualized), which is some multiple of the carry earned.

Moreover, look a bit closer at that carry, 125 bps annualized. That turns out to be about 10.5 bps a month. This year, the dollar has moved on averaging almost 1.3% a month so far this year. On the other hand, the euro rose around 14.5% against from mid-April to early August. The carry earned is overwhelmed by the price appreciation. Some participants may have bought the euro for yen and said it was about the carry, but it was really a momentum trade.

To reiterate, the use of the Swiss franc and Japanese yen as a funding currency is not limited to the currency market, where the volatility, as we have shown, is frequently too great to make a carry strategy practical. The issue is then which currency is a better funding currency now, the yen or the Swiss franc?

The Swiss franc offers more negative short-term interest rates and is less volatile than the yen. Specifically, three-month franc LIBOR was fixed at minus 72.5 bps today. Three-month yen LIBOR was fixed at about minus three bps today. Three-month implied volatility is 7.5% annualized for the Swiss franc and 8.7% for the yen. Both countries are experiencing little price pressures. Japan's July headline CPI was 0.4% year over year, while Swiss inflation was 0.3% (0.6% in the EU harmonized methodology). The Swiss economy growth is weaker but less volatile than Japan. Japan's economy grew 1.0% in Q2 after 0.4% growth in Q1. The Swiss economy grew by 0.3% in Q1. When it reports Q2 GDP in early September, it is expected to have risen by around 0.5%.

On balance, these fundamental considerations suggest that the Swiss franc may be a better funding currency now than the yen. Technical considerations suggest some caution. The franc has depreciated by around 5% against the yen between July 10 and this past Monday. This left the technical indicators a bit stretched. Yesterday's big advance of the franc over the yen helped lift the RSI, and the Slow Stochastic has already turned up. Minor bullish divergences are evident. The MACD looks poised to cross higher before the weekend.

The cross fell into the lower end of the range seen in the second half of Q2 (~JPY112.50). A move above JPY114.30, last week’s high, is needed to confirm a franc low is in place. The JPY114.65-JPY114.75 area houses the 38.2% retracement objective of the last leg down that began on July 25 near JPY118 and the 20-day moving average. The franc has not closed above its 20-day moving average against the yen since July 21.

This article was written by

Marc Chandler profile picture
15.13K Followers
Marc Chandler has been covering the global capital markets in one fashion or another for 25 years, working at economic consulting firms and global investment banks. A prolific writer and speaker he appears regularly on CNBC and has spoken for the Foreign Policy Association. In addition to being quoted in the financial press daily, Chandler has been published in the Financial Times, Foreign Affairs, and the Washington Post. In 2009 Chandler was named a Business Visionary by Forbes. Marc's commentary can be found at his blog (www.marctomarket.com) and twitter www.twitter.com/marcmakingsense
Follow

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Recommended For You

Comments (3)

To ensure this doesn’t happen in the future, please enable Javascript and cookies in your browser.
Is this happening to you frequently? Please report it on our feedback forum.
If you have an ad-blocker enabled you may be blocked from proceeding. Please disable your ad-blocker and refresh.