CHF: No Breather For The SNB

This Thursday’s Swiss National Bank (SNB) quarterly monetary policy meeting comes against a backdrop of Swiss franc (CHF) outperformance, with the currency the second best performing in G10 this year. We look at what is driving CHF’s asymmetric performance this year and its role as safe haven asset.

A Traditional Safe Haven

The unprecedented economic shock and financial repression caused by Covid-19 have pushed investors to traditional safe havens, so it’s perhaps no surprise to find CHF the second-best performing G10 currency YTD. However, the Swedish krona (SEK), one of the most cyclical European currencies, was the top performer. Therefore, it may be wrong to assume that risk-off was the only driver of G10 FX.

The Swiss franc is considered a safe haven for several reasons:

1) Switzerland has a record net international investment position (NIIP), i.e. accumulated current account surpluses
2) Low rates have made CHF an attractive funding currency
3) Switzerland is a stable country with defensive industries in a challenging region
4) It also has strong institutions

During periods of financial market turmoil, Swiss investors repatriate foreign assets (the country’s NIIP equals 115% of GDP). Global investors close risk-on positions funded in CHF and equity investors increase their allocations to defensive sectors, which are heavily weighted in the Swiss Market Index (SMI). All these factors drive the CHF outperformance during challenging times.

The opposite tends to be true during expansion as Swiss investors recycle current account surpluses abroad, global investors build up risk-on positions funded in CHF, and equity investors increase their allocation in more cyclical markets. The general safe-haven flow has reduced to just European risk-off in the last 2-3 years, however, leaving minimal CHF outflows.

An Asymmetric Reaction in 2020

Europe has seen two positive catalysts in the past few months, the ECB’s PEPP and the EU Recovery Fund. The deviation from the capital key allowed under PEPP meant purchases have favoured the euro area periphery; within a month, the BTP/Bund spread narrowed, but European stocks EUR/CHF remained flat.

The BTP/Bund spread also narrowed after May’s announcement of the initial EU Recovery Fund proposals, and EUR/CHF quickly reacted on the upside, moving from 1.05 to 1.09 within two weeks. But it has been losing momentum since then. Despite the 5% rally in EUR, and the additional 40bps easing in BTP/Bund spread, EUR/CHF moved back to 1.0750.

We believe several reasons explain the CHF’s muted reaction:

1) The recovery in confidence from Swiss investors in Europe will take time. The EU Recovery Fund is a clear positive, but it is unknown whether it will really turn the EU into a fiscal union.

2) The liquidity-driven rebound in risk has kept global yield at very low levels. The US 10-year rate has been stuck in a 50-75bps range since June, despite the stronger rebound in economic activity and the 20% rally in US markets. The new framework from the Fed should keep rates low for longer.

3) Inflation in Europe is a problem. In August, the region sided into deflation for the first time in four years. The German VAT cut and the fall in oil prices are partial explanations, but it will be critical for the ECB to show no signs of complacency.

4) The lack of follow-through has cooled enthusiasm for long EUR/CHF. Many speculators have probably stopped tactically trading CHF, leaving structural inflows from the big current account surplus (the basic BoP equals 15% GDP) and the outflows from one-sided SNB intervention, creating a floor at 1.05. This has reduced volatility and taken EUR/CHF off the radar of many macro investors.

What Could Break the 1.05-1.09 Range?

At this stage, there appears to be no strong catalysts to push EUR/CHF higher.

The SNB can lift the pair to 1.0850-1.0900, but they cannot really do much more. Intervention over the last six months accounts for roughly 11% of GDP, and the SNB’s balance sheet reached 135% of GDP. As the SNB president, Thomas Jordan, said, interventions prevent ‘an excessive appreciation of the franc, but also expand the SNB’s balance sheet and thus increase financial risks’. Moreover, Jordan also noted that interest rates could not ‘lower interest rates indefinitely’. Overall, the SNB will probably only slow down the franc appreciation.

Therefore, the EUR/CHF recovery will only follow the world recovery once the interest rates start rising, probably driven by higher inflation. However, although inflation may come more quickly than expected, it will probably remain moderate in the next 18 months.

Finally, another catalyst for higher EUR/CHF could be if Swiss banks start charging negative rates to a broader base of wealthy clients. They will push them out of costly cash, but it does not necessarily mean that CHF outflows will accelerate (they can invest in FX-hedged equities).

On the downside, the most important short-term catalyst is a rise in the probability of a no-deal Brexit. GBP weakness may be a precursor of the deleveraging in long EUR and the building of short positions in GBP/CHF. If GBP goes to 1.10 -1.15, it might be hard for the SNB to protect 1.05.

The second catalyst would be severe mobility restrictions from soaring Covid-19 cases in Europe. European governments have tried to keep economies open as hospitals remain below capacity. However, the rates of deaths and hospitalisations have picked up in Spain and France, raising concerns over capacity.

The third catalyst could be the US Treasury’s next currency manipulation report. As Switzerland meets the three criteria to be labelled a currency manipulator (LINK), the US can initiate actions if no progress is made one year after engaging in discussion. The US could impose ‘penalties’, but, given the exceptional environment, a more flexible approach is likely even if the official criteria are met.

The last catalyst would be a resurgence of the Italian risk. Seven Italian regions go to the polls for regional elections early this week in what will be the first test for Prime Minister Giuseppe Conte since the Covid-19 outbreak and the nationwide lockdown. The elections are unlikely to trigger a political crisis, but a victory of the far-right, especially in Tuscany, will put pressure on the government and, as a result, the BTP/Bund spread.

Conclusion

Swiss franc performance has been asymmetric this year. It gradually strengthened from 1.10 to 1.05 but failed to rebound when risk sentiment improved. In a falling rates environment with a weak inflation outlook in Europe, the incentives for capital outflows have significantly reduced. Real economy flows have therefore been the most important driver, pushing the currency higher. SNB intervention helped to soften CHF strength but failed to prevent it from significantly diverging from the EUR/USD, while speculative flows have stopped. Swiss investors have a large foreign underweight position, but the recent price action demonstrated that the current account recycling will take a lot of time.