CIO Viewpoint: Containing the Swiss franc

The coronavirus is the latest in a list of factors reinforcing the franc’s international role as a safe-haven currency. The franc’s value is broadly driven by the state of the global economy, and more particularly, by the health of the surrounding eurozone. Switzerland’s own economic wellbeing matters, but less so.

Since the beginning of 2018, the Swiss currency has gained more than 10% against the euro, and climbed more than 1.8% year-to-date as Germany, the region’s biggest economy, and the eurozone as a whole, stagnated (see chart). Over the period, Switzerland’s trade balance has improved with rising demand for Swiss exports, and the US/China trade tensions fuelling investors’ risk aversion.

The Swiss franc’s role as a safe-haven currency for the rest of the world creates problems for the Swiss economy. The strength of the franc undermines exports and hurts the country’s tourist industry.

Such was demand for the franc that five years ago the SNB cut interest rates below zero to -0.75%. That made the currency less attractive for investors to hold.

Nevertheless, the Swiss economy has slowed dramatically. Swiss Gross Domestic Product expanded 2.5% in 2018 and we estimate it may have slowed to 0.9% in 2019. With inflation expected to rise only 0.4% this year as domestic demand, wage growth and household spending continue to slow, it seems likely that the SNB may have to cut interest rates even further into negative territory, to -0.85%, later in the year.

Of course, not everyone is happy with negative interest rates. Pension fund returns have been eroded and financial institutions and their clients spent an estimated 2 billion francs in interest payments on deposits with the central bank last year.

“I understand the discontent of the banks and savers,” SNB President Thomas Jordan said last month. “But we need negative rates.” Without them, he argues, the franc would appreciate further and so the economic benefits outweigh the costs.

On watch

The SNB’s other main tool is currency intervention. The central bank has used its currency reserves to intervene in foreign exchange markets and limit the franc’s appreciation. However, with a balance sheet reaching a record 864.6 billion francs in November 2019, the SNB now seems to have limited appetite to intervene enough to weaken the franc materially. For a central bank of the SNB’s size, its investment portfolio is unusually large, equivalent to 122% of Swiss GDP and one-sixth the size of the ECB’s balance sheet.

Currency intervention also creates a broader dilemma. In mid-January, the US Treasury re-added Switzerland to a “watch-list” of currency manipulators. Switzerland meets the US’s criteria for currency manipulation on two counts: the size of the economy’s trade surplus with the US and its current account surplus, which is more than 10% of GDP. The manipulator label would matter because the US may exclude a country on the list from tendering for US government contracts.

The US also has a third criterion for its currency manipulator label: whether a country spends more than 2% of nominal GDP on intervention. Switzerland’s foreign exchange purchases “have increased markedly” since mid-2019, the US Treasury said in January. Over 2019, the SNB’s holdings in euro investments rose by around 19 billion francs, equivalent to around 2.7% of nominal Swiss GDP, although it is possible other factors may account for some of this rise.The SNB has reminded markets that it manages the franc in accordance with its mandate to maintain price stability for the Swiss economy. Its interventions are “motivated purely by monetary policy” and “aimed at addressing the negative consequence for inflation and the economy through a highly valued franc,” it has said. The central bank’s policymakers next meet on 19 March 2020.

Adapting to franc strength

The SNB’s policy measures have forced Swiss companies to adapt their businesses to negative rates and the strong franc. For the past five years, Swiss companies have reacted by diversifying production and investments in lower-cost countries. They have also increased production-chain automation by investing in robotics.

The currency impact has proven manageable for many Swiss firms as they were able to pass on higher costs to their customers. Businesses that are less able to offer differentiations in terms of products, services or prices, have increasingly outsourced their activities beyond Switzerland.

The outlook for 2020 is unusually complicated because of the virus outbreak, its impact on the global economy and the policy response from governments and major central banks. In our base scenario, where the impact of the virus is quite meaningful but transitory and global policy makers provide significant support, the pick-up in global trade and manufacturing that started in late 2019 should resume later in the year. This should support the EURUSD as well as the correlated EURCHF. Additionally, and importantly, this improved global environment would allow Swiss residents to “recycle” a strong trade balance abroad through portfolio outflows. This should weaken the Swiss franc. We currently forecast EURCHF at 1.10 by the end of the year.

Hedging virus risks

Still the virus situation remains fluid and it could turn into something more sinister with more lasting implications for economies and markets. If so, this would trigger some further pressures on the franc, which would demand more SNB intervention or additional interest rate cuts.

For investors, the Swiss franc continues to offer sound hedging properties in this risk-averse environment, mostly related to European risks, alongside other traditional safe havens, such as gold, US Treasuries and the yen. Faced with high valuations, selecting the right hedging instruments at the time of implementation is crucial.

In a January interview, Mr Jordan described his almost eight years in the SNB presidency role as “the most difficult job in Switzerland.” Given the pressures on the franc, the limited room to cut rates further and the political and financial risks to the central bank’s forex interventions, the job may be about to get even harder.

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