Savour International

The pressure on Swiss exporters was too great. The highflying Swiss franc has squeezed profit margins and jeopardised jobs. Future corporate profits have been additionally threatened by looming deflation. To counter these undesirable developments, the Swiss National Bank announced on 6 September 2011 that it would enforce a minimum exchange rate for the euro against the franc.

This amounts to a de facto surrender of the SNB’s monetary independence. As long as the decision remains in effect, the SNB will defend a minimum euro exchange rate of CHF 1.20 “with the utmost determination”. It is prepared to buy foreign currency in unlimited quantities to keep the cap in place. The SNB’s move is not uncontroversial – but so far it has been successful. The scale of the interventions already made by the SNB to enforce the 1.20 cap is not yet known. It is also unclear how long the SNB will defend its target or whether it will modify it. In our view, 1.20 is a credible minimum rate for the euro against the franc over the coming months. The only risk is a serious escalation of the euro crisis.

Inflation in the pipeline?

The SNB’s measures to weaken the franc will lead ultimately to a substantial expansion of the monetary base (M0 money supply, consisting mainly of commercial bank deposits held with the SNB). But this does not necessarily mean a major increase in M3 money supply (deposits by non-banks with the commercial banks), which is the relevant aggregate for inflation. For that to happen, the commercial banks would have to increase their lending significantly. With the economic outlook becoming increasingly gloomy, however, demand for credit (except mortgages) looks set to remain subdued despite low interest rates. In other words, as long as the flows of capital into the Swiss franc remain parked with the SNB as surplus demand deposits, temporary massive buying of foreign currency will not have an inflationary impact.

Yield gap set to close?

Overall, Switzerland’s bond market is unlikely to decouple from interest rate trends on the major markets of the developed countries. The appetite for risk in Switzerland can be expected to move in tandem with the rest of the world. Interest rates will stay low:

• The Swiss bond market is relatively small and illiquid. This means that it is strongly influenced by  supply and demand. The supply of Swiss federal bonds is fairly meagre, because Switzerland has a low level of debt. But demand is sometimes high, especially at the very long end. Insurance companies, in particular, use federal bonds as a means of managing the structure of their balance sheets. This can lead to erratic movements in the yield curve. Medium- and long-term interest rates in Switzerland can be expected to edge upwards even without immediate inflationary pressures – the yield gap versus the Eurozone has already narrowed at the very long end:
• The SNB adjusted its inflation forecast downwards after the announcement of its new exchange rate  policy. However, bond markets react primarily to inflation expectations. We expect inflation expectations to rise, depending on how high the SNB’s currency purchases turn out to be.
• The interest rate gap versus the Eurozone, combined with the minimum EUR/CHF rate, creates  opportunities for apparently risk-free carry trades. Investors can borrow in Swiss francs – as they did before the financial crisis – and invest the money in higher-yielding foreign bond markets. Such a strategy rests on the assumption that the 1.20 cap will hold – otherwise, the currency risk remains. Thus large-scale carry trades are unlikely as long as the euro crisis continues. Moreover, now that hedging of EUR positions is regarded as unnecessary, interest rates at the short end will also move closer together, as has already happened in some cases.

In the medium-term section of the yield curve (by far the most liquid part), there has so far been no convergence between Eurozone and Swiss interest rates.

Implications for investors

The yield gap between the CHF and EUR, combined with the SNB’s intervention policy, creates carry trade opportunities in the Eurozone, supposedly with no currency risk. But the SNB’s new policy does not amount to a firm peg. The SNB reserves the right to modify or abandon its exchange rate target at any time without warning. Unhedged investments in EUR assets therefore carry a residual risk. The risk that the SNB’s policy will come to grief increases with time and depends on how the debt crisis evolves. On the other hand, if the inflation gap versus the Eurozone continues, a fair exchange rate in terms of purchasing power parity will approach the 1.20 mark in the medium term. There is no precise timetable as yet for when and how the SNB will switch back to a normal exchange rate policy. Investors based in Swiss francs should therefore not completely unwind their strategic hedging positions. In the short term, however, a partial unwinding makes good sense tactically. Hedging costs are reduced and investors will be in a position to profit from an unexpected strengthening of the euro. The size of the tactical deviation from the strategic hedge will depend on the investor’s risk tolerance. In our investment management portfolios, we have de-hedged up to a maximum of 50%. We recommend that this tactic be reviewed in three months’ time at the latest. For investors based in euros, Swiss franc assets carry a one-sided currency risk, because an appreciation of the Swiss franc is now being prevented by the SNB. Moreover, Swiss interest rates are hardly attractive at present. The yield on short-term Swiss federal bonds, for example, was negative in mid-September. Many investors are now looking for an alternative to the franc, though demand for the franc is still high. An analysis of possible alternatives can be found in the Money Market section.