G10 FX Weekly: Worried About Geopolitics? Look to the Swiss Franc!

Summary

• Geopolitics remains a constant risk to markets.
• As the ultimate FX haven, the Swiss Franc (CHF) is always attractive during heightened geopolitical and economic uncertainty.

Market Implications

• As most G10 FX currency pairs are rangebound, CHF pairs will probably trade within established ranges.
• If geopolitical risk intensifies, however, expect CHF to rally against its developed market counterparts.
• This scenario will take EUR/CHF and GBP/CHF to the 2022 lows, with new all-time lows possible if geopolitical risks are protracted or multiply.

Introduction

In times of serious economic and/or geopolitical dislocation, FX investors flock to the Swiss franc for the safety of Switzerland’s status as a haven. This has happened repeatedly throughout history, especially in the past 15-20 years.

As my Macro Hive colleague Henry Occleston wrote recently, geopolitics matters greatly, and risks remain that could drive flows into the CHF.

Specifically, Henry highlights three key near-term geopolitical risks: an isolated and vulnerable Iran, trouble around Turkey’s elections, and further Russian escalation of its war against Ukraine.

Henry argues that markets are almost certainly under-pricing these potential geopolitical risks, that subsequent flashpoints are high-risk, and that such events may unfold rapidly.

Should geopolitical risk intensify, it will probably impact the euro area and UK most, as much of the prospective turbulence is on Europe’s doorstep.

As such, expect both EUR/CHF and GBP/CHF to drop materially, likely to initially trade back to the 2022 lows, with possible new all-time lows, if the risks are protracted or multiply.

CHF’s History as a Haven

CHF has attracted heavy haven flows several times in the past 15-20 years. EUR/CHF has been the main currency pair conduit for these flows and is the most liquid and heavily traded of all the Swiss currency pairs.

Below are some of the more notable milestones of the past two decades.

The Global Financial Crisis

The Global Financial Crisis (GFC) of 2007-2008 caused severe dislocations across all asset classes. This included a sharp sell-off in equities and a flight-to-safety into fixed-income markets, such as US Treasuries and German government bonds.

In FX, the Swiss franc rallied materially. From October 2007 to March 2009, EUR/CHF fell about 10%, from ~1.68 to ~1.51. March 2009 is an important milestone as it was when the S&P 500 bottomed out.

European Sovereign Debt Crisis

While markets started to regain some composure in the spring of 2009, EUR/CHF traded broadly sideways. The next leg lower, however, began in the autumn of 2009 on the back of the developing European Sovereign Debt Crisis.

Euro-area peripheral sovereigns were struggling under the weight of excessive debt loads, and there was concerted selling of Greek, Italian, Spanish and other non-core European government bonds.

With this economic turbulence occurring right on its doorstep, the flow of funds into Switzerland was relentless. After trading sideways for about six months following the S&P’s nadir, EUR/CHF quickly gathered downside momentum.

The price action was all one-way until the summer/autumn of 2011. In just over two years, EUR/CHF fell about 25%, from ~1.51 to ~1.13.

The Swiss National Bank Draws a Line in the Sand

This caused a ‘massive overvaluation of the Swiss franc’ in the words of the Swiss National Bank (SNB) – an overvaluation that they said ‘pose[d] an acute threat to the Swiss economy and carrie[d] the risk of a deflationary development.’

To counter the deleterious economic impact of its strong currency, the SNB imposed a floor of 1.20 for EUR/CHF, pledging to sell the franc at that level in unlimited quantities.

This continued until January 2015, when the European Central Bank (ECB) enacted negative rates and quantitative easing. The SNB then abandoned the 1.20 floor.

Years of Relative Calm

What followed was an untradeable period of intense volatility for CHF traders, until the currency settled into a trading range.

To be sure, the SNB itself introduced a negative policy rate and regularly commented that the franc remained overvalued. This was expected given global disinflationary concerns. The SNB also intervened regularly to combat CHF strength, although to a lesser extent than when it was defending the 1.20 floor in EUR/CHF.

Since the SNB abandoned its 1.20 line in the sand, EUR/CHF has never convincingly traded above the 1.20 level.

The Ukraine War

Once the initial shock abated after the SNB stepped away from the 1.20 level, EUR/CHF settled into a ~1.05/1.20 range until the Ukraine war began a year ago.

There was back-and-forth price action during this period, but on the eve of the war, the pair was near the lower end of the range, with the CHF having rallied steadily after EUR/CHF traded back to ~1.20.

The war clearly impacted the franc. From February 2022 until the autumn, EUR/CHF dropped roughly 10%, with the franc trading at a record high against the euro (on a closing basis).

The SNB and the CHF

Since the EUR/CHF trough printed in September, the pair has been grinding higher, following the euro’s general trend of recovering together with energy prices falling (as discussed here).

One key point about the CHF is the SNB’s view of the currency. As outlined above, for most of the past two decades, Swiss policymakers have viewed their currency as overvalued.

Most importantly, the central bank has intervened aggressively to combat CHF strength. The defence of the 1.20 level in EUR/CHF is an obvious example, with several other more discrete interventions having occurred.

This dynamic has now shifted. Until last year, the SNB (and other central banks) were mostly concerned about disinflation/deflation. However, over the past year, central banks have been tightening policy to combat high inflation, including the SNB.

One key element in this policy shift is the SNB’s view of CHF. After fighting CHF strength to counter disinflation, the SNB now welcomes a stronger franc, as it slows imported inflation.

Instead of impeding a stronger currency (as it had for decades), the SNB will permit an appreciating franc. The SNB is poised to tighten monetary policy again and   support the franc in currency markets.

For a generation of CHF traders, this is a game changer. They will no longer fear being long the currency, fighting the central bank. And this is especially important during geopolitical and economic uncertainty.

A Look at Two CHF Pairs

If geopolitical risks intensify, two of the key FX pairs to watch will be EUR/CHF and GBP/CHF. If haven flows into the Swiss franc accelerate, both the euro and pound will face acute selling pressure.

EUR/CHF

In September 2022, EUR/CHF traded at an all-time low (on a closing basis), below 0.95. As outlined in our recent EUR/USD piece, the Ukraine war hit the euro very hard, impacting EUR/CHF.

Since bottoming out in September, the pair has rebounded slightly to sit just beneath parity. The recent ~six-month range has held and will keep holding in the coming months absent any increase in geopolitical risk.

On any increase in geopolitical instability, however, expect EUR/CHF to trade back to its previous trough, possibly reaching a new record low.

GBP/CHF

As with EUR/CHF, GBP/CHF also traded at an all-time low (on a closing basis) last September because of geopolitics and the disastrous Truss/Kwarteng ‘mini-budget’.

GBP/CHF has also rebounded from the 2022 low and has since traded in a ~1.10/1.15 range. Absent any sharp haven demand for the franc, this range should continue in coming months.

Again, though, as with EUR/CHF, any intensification of geopolitical tensions will return GBP/CHF to the all-time low. Additionally, given our bearish GBP bias, GBP/CHF would be our preferred method of initiating CHF longs.

Conclusion

Along with most of G10 FX, CHF pairs have traded within established ranges so far in 2023. This could all change if geopolitical tensions intensify in coming months.

Switzerland has long been a haven for investors during geopolitical and/or economic turbulence, with many examples in the past two decades where CHF has rallied on a flight-to-safety.

Should any of the potential geopolitical flashpoints become more acute this year, expect the franc to rally materially. For EUR/CHF and GBP/CHF, expect the record price troughs of recent months to return, possibly reaching new all-time lows.

Richard Jones is a Macro Strategist for VDK Capital, a London-based venture capital firm. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side. 

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)