Forex Investment and Currency Trading

Gone are the days of early 2007 when the Swiss National Bank (SNB) aired its discontent with the weakness of the CHF. In sharp contrast to worrying about currency weakness, SNB Governing Board member Jordan announced last Thursday when discussing ways to ease monetary policy once the key policy rate target had been reduced to zero that “we could engage in quantitative easing and we could intervene in foreign exchange markets [to weaken the franc] or we could buy bonds and try to influence long-term interest rates.” It is much more likely that the SNB would buy long-dated bonds
to influence monetary conditions than intervene in the currency markets with the former option having a more “guaranteed” outcome. Indeed, the success of FX intervention could be low with fundamental factors suggesting that the multi-week EUR/CHF rally could be running out of steam.

While EUR/CHF is clearly affected by the level of interest rates in the Eurozone relative to Switzerland, the pair has historically not followed yield differentials nearly as closely as EUR/USD or EUR/GBP. Nonetheless, the increase in market expectations for aggressive easing in Switzerland appears to have been the key variable behind the recent recovery of EUR/CHF. The two-year Eurozone – Swiss swap spread has increased from 112bp on October 31 (when the Swiss KOF leading indicator showed a sharp unexpected decline) to presently stand at 186bp. However, one now views the risks to this spread as to the downside with market expectations for Swiss rates (0.00%) unable to decline further, while the deepening Eurozone recession may push the market to price in further easing from the ECB.

Looking ahead, CHF is likely to be an outperformer in 2009 with the OECD now looking for the G7 economies as a whole to contract by -0.7% next year. CHF has consistently appreciated over the last twenty years during periods of economic slowdown for the G7 countries, and depreciated during periods of recovery. The pattern is likely due to a “safe haven” bid as well as the country’s increasingly large current account surplus over the time period.

The relationship between the OECD leading indicator for the G7 countries and CHF has experienced only one major period of breakdown from October 1993 to December 1994. This divergence can be explained by the fallout from the ERM crisis. In the two years that followed Black Wednesday (September 16, 1992) when the GBP was forced to leave the Exchange Rate Mechanism (ERM), several of the European currencies, including GBP, FFR & SEK, experienced a period of considerable depreciation versus DEM. The volatility between European currencies likely produced a safe haven bid for CHF, preventing depreciation when the G7 leading indicator improved in 1993.

In addition, Switzerland’s large current account surplus, which stood at 10.1% of GDP as of 2Q 2008 (in contrast to the small current account deficit of the Eurozone), suggests that CHF will likely experience further appreciation in the year ahead. The current account surplus failed to produce
CHF appreciation versus EUR from 2003 to 2007 as low interest rates in Switzerland and very low levels of volatility created an environment in which the CHF became increasingly attractive as a financing currency for “carry trades” and the funding of mortgages in various countries throughout Eastern Europe such as Hungary and Poland. However, in an environment of elevated levels of volatility, tighter lending standards, and reduced liquidity, the weakening effect on CHF from its use as a financing currency is likely to be extremely reduced. As such, the correlation between the Swiss currency and measures of risk aversion may continue to weaken in the months ahead with the relationship between the VIX and CHF appearing to have already largely broken down since mid-November.