Haven appeal of Swiss franc will fade
The Swiss franc and US Treasury bonds are the final remaining haven assets with international appeal. In contrast, German bunds are denominated in euros, the Baweifnk of Japan’s massive quantitative easing is weakening the yen, and gold has lost its lustre as inflation has stayed low among developed economies.
Switzerland’s currency has been in demand this year as emerging markets have fallen around the world. But in spite of its haven status, investors should be sellers of the franc as the currency is set to weaken in 2014.
First, the Swiss National Bank is highly unlikely to abandon its cap on the exchange rate and start raising interest rates when other central banks begin tightening monetary policy over the next few quarters. The SNB claims the ceiling on the franc is needed for the foreseeable future given Switzerland’s near zero inflation rate.
Policy makers believe an increase in interest rates would endanger the limit on the currency and risk tipping the economy into deflation. The SNB is therefore likely to be one of the last central banks to start normalising monetary policy over the next few years.
Second, the large scale deleveraging that Swiss banks have undertaken since the credit crunch began, primarily through selling foreign assets and returning capital back into francs, appears to have finished. From 2007 to 2012, Switzerland experienced more than CHF200bn of inflows as local banks cut loans abroad.
That counts as extreme repatriation in an economy with a current GDP of CHF600bn. But in the first three quarters of last year, Swiss banks reversed course and increased their net lending abroad. This puts the balance of payments on track in 2013 to record annual outflows from domestic banks for the first time in a decade.
Third, the unwillingness of Swiss portfolio managers to purchase foreign assets since the eurozone crisis began in 2010 may also finally be coming to an end.
When the region’s debt crisis erupted, investors favoured the franc as a haven substitute for the old deutschemark. Even as eurozone equity and debt markets started to recover last year, Swiss asset managers were reluctant to reduce the high levels of ‘home bias’ in their portfolios in case the debt crisis flared up again.
That helped to underpin the strong value of the franc against the euro and dollar. But as foreign asset markets have continued to benefit from rising global growth, domestic portfolio investors are also now beginning to reduce their overweight positions in Swiss francs.
Admittedly, the currency is likely to remain supported by Switzerland’s large current account surplus this year. For the first three quarters of 2013 alone, the current account’s positive balance exceeded CHF60bn. For the year as a whole, it is likely to be well over 10 per cent of GDP. That provides substantial support and underpins the franc’s status as a haven asset.
But balance of payments accounting also overstates the significance of Switzerland’s current account surplus in relation to the franc. Trade in goods only makes a modest contribution to the surplus.
In contrast, investment income from Switzerland’s large net foreign assets, financial sector earnings and revenue from merchanting have all increased sharply over the past decade. But these flows may not necessarily be converted into francs. As SNB President Thomas Jordan said in a speech last year, “merchanting refers to trade, denominated primarily in US dollars, that does not cross the domestic border”.
The franc is also likely to remain supported by fears that the eurozone will edge towards deflation, prompting the European Central Bank to ease monetary policy further. In particular, if the ECB was to set its deposit rate below zero or engage in large-scale asset purchases as other central banks have since the financial crisis, the franc would benefit from haven-seeking inflows, resulting in the SNB selling domestic currency to enforce the CHF1.20 cap against the euro.
The risk of further ECB easing this year cannot be discounted given eurozone headline inflation was only 0.7 per cent in January. But the franc would be at risk if the SNB matches any move by the ECB to pursue negative interest rates.
Furthermore, the broader picture of recovery in the US, UK, Japan and Germany, less risk in peripheral eurozone markets, and the SNB’s commitment to maintain the cap on the franc and to be slow in raising interest rates, suggest risk-averse investors should favour the US dollar and Treasury bonds rather than the franc when seeking to hedge portfolios.
The dollar should benefit this year from the Fed tapering its asset purchases while US Treasuries will be in demand if emerging market turbulence intensifies.