Is The Swiss Franc Still Overvalued?

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Includes: DRR, ERO, EUFX, EUO, FXE, FXF, ULE, URR
by: Citylytics

Summary

The CHF depreciated roughly 6% against the euro through the second half of the year.

Stronger CHF depreciation against the EUR would require more restrictive monetary policy from the ECB.

High inflationary lag of the Swiss economy vs. the eurozone implies that the SNB has more time before the first rate hike.

The EUR/CHF is set to hover around current levels for the time being, only to increase further once the ECB announces QE exit and the ECB rate hike becomes apparent.

The Swiss National Bank (SNB) has a plethora of reason to be satisfied with the global financial movements in the past few months. The uncertainty surrounding the European union existence dropped significantly in the aftermath of French and German elections. The systemic EUR risk thus decreased and the demand for the CHF as a safe haven currency eased. In line with that, the CHF managed to depreciate roughly 6% against the euro through the second half of this year.

The SNB acknowledged those positive movements at their last meeting and stated that this development is helping to reduce the significant overvaluation of the currency to some extent. However, the SNB still emphasized that the CHF remains highly valued and that the situation on the foreign exchange market is still fragile. Indeed, the EUR/CHF is trading at roughly 30% higher levels compared to the pre-crisis ones (see chart below). Therefore, the SNB once again committed to intervene on the FX market if necessary.

Chart 1: EUR/CHF and USD/CHF movements

Source: Reuters

In spite of the supportive low yield environment, the Swiss economy recovery remains moderate with an average GDP growth of 0.45% yoy so far this year (versus 1.4% in 2016). Recent CHF depreciation will certainly boost price competitiveness of Swiss companies in the upcoming period but I don't expect to see any spectacular implication on the growth.

Chart 2: Switzerland GDP growth (yoy, %)

Source: Reuters

At the same time, inflationary pressures increased recently to the highest level in past six years (+0.66% yoy in October) but are still well below the so called healthy inflation of around 2%. In such circumstances I believe that the SNB will stick to its ultra-expansionary monetary policy for the foreseeable future. Indeed, any sign of tighter monetary policy outlook would probably result in at least moderate CHF appreciation. The latter would lower import prices and lower the inflation. In my view, this is the risk that the SNB is not willing to take after fighting deflation for the past six years.

The fact that the SNB's FX reserves are at the record high (around 100% of GDP) and that the SNB softened their CHF rhetoric (considers the CHF as still highly valued but no longer overvalued) implies that the SNB will probably refrain from FX interventions unless necessary. This suggests that the SNB is not going to actively depreciate the CHF further through the FX interventions.

Chart 3: The SNB's FX reserves

Source: Reuters

In such circumstances I see the EUR/CHF exchange rate trading around the current levels for the time being. Minor appreciation episodes are not to be excluded in the risk off periods and periods of increased geopolitical tensions. However, I would use the latter as an opportunity to short the CHF.

On the other hand, a sustainable further CHF depreciation against the EUR would require more restrictive monetary policy from the ECB. The latter is something that we won't see any time soon in my view (please see "ECB: No Rate Hike On The Horizon").

However, once the ECB announces the end of QE and the first ECB rate hike becomes apparent, the EUR/CHF should have no problem breaching the 1.20 mark, in my view. For the 2018, the SNB anticipates an inflation rate of 0.4% while in 2019 the SNB expects inflation of 1.1%. At the same time the ECB forecasts inflation of 1.2% in 2018 and 1.5% in 2019. The Swiss inflationary pressures are lagging significantly behind the ones of the euro area (see chart below). This means that the SNB will have more time before hiking rates which will allow them to enter the hiking cycle at more favorable EUR/CHF levels.

Chart 4: Expected inflation movements

Source: SNB and ECB

Meanwhile, the USD/CHF is set to move toward parity in my view and in line with the expected Fed's hiking cycle.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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