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How long until parity?

The Swiss National Bank (SNB), staying true to its mantra, continues to call the franc “highly valued.” But like so many things, a currency valuation is a matter of perspective (or the model employed). In any case, the value of Switzerland’s currency (against the euro) actually is almost cheap, at least on the basis of purchasing power parity.

 

Constant inflation differentials…

The persistently (and partly surprisingly) high inflation data continue to fray tempers not just among financial analysts, but increasingly also among consumers. Fewer and fewer experts believe that the current burst of inflation is merely a temporary phenomenon – the “inflation transitionistas” camp is rapidly shrinking. Nerves are bound to be raw or at least severely under strain even among some central bankers in light of the stickiness of the high (and increasingly broader-based) inflation. It’s ultimately no secret that central banks, too, haven’t yet really figured out the mechanisms of inflation and how to predict them. Meanwhile, inflation data, and especially inflation differentials between different countries, also have relevance for currency markets. If, for example, inflation in “Country A” stays lower than inflation in “Country B” for a lengthy period, then ceteris paribus, the real exchange rate of “Country A’s” currency declines. This means that “Currency A” buys less in “Country B” than before – its purchasing power decreases. Since the real external value of a currency (under simplified assumptions) should fluctuate around a certain equilibrium value over the long run, it takes an equalizer valve to correct large deviations. This corrective is the nominal exchange rate, which in the case of “Country A” must rise over the long term to preserve the purchasing power of “Currency A.”

 

Richly valued?
At least not on the basis of producer prices

Euro vs. Swiss franc and purchasing power parity (based on producer price indices)

Sources: Bloomberg, Kaiser Partner Privatbank

 

…make the franc strong

Switzerland is a textbook example of a typical “Country A.” For decades, inflation in the Swiss Confederation has mostly been lower than inflation in its most important trading partner countries. The inflation gap versus the Eurozone, for example, has widened since 2009 by 17% as measured by consumer prices and by 25% as gauged by producer prices. This “law of nature” hasn’t changed at all this year even in the midst of the “perfect inflation storm.” And a look into the crystal ball doesn’t augur anything different in the future. The Swiss National Bank (SNB) itself projects an inflation rate of “just” 0.6% for 2023. The European Central Bank and the US Federal Reserve, on the other hand, see a “1” or “2” in front of the decimal point for the next two years. The SNB’s assertion recently reiterated in September that the Swiss franc remains “highly valued” corresponds less and less with the inflation picture with each passing day, at least when we look at the relations versus the euro and the US dollar. Based on purchasing parity indices calculated by Bloomberg, the franc has actually become slightly undervalued by now against both of those currencies, at least on the basis of producer prices.

The question is how long the SNB intends to continue intervening on the currency market.

When will the SNB lower its EUR/CHF intervention threshold?

But to be equitable and to avoid succumbing to confirmation bias, one must add that the Bloomberg analysis based on consumer prices backs the SNB’s assertion and appraises the franc as being a bit above its “fair value” against the euro. Nevertheless, the EUR/CHF exchange-rate fair value is decreasing in front of our eyes as a result of the continual inflation differential, and the same goes for the SNB’s exchange-rate index over the last 12 months. Moreover, there is also anecdotal evidence – complaints about an overly strong franc from the Swiss manufacturing sector have more or less fallen silent in any case. So, it’s definitely warranted to ask how long the SNB intends to continue intervening on the currency market. Our expectation is that as long as “exchange-rate management” can be done on the cheap and costs “only” a few billion francs, the benefits of intervening outweigh the potential drawbacks. However, the risk/reward reasoning gets out of whack if significantly more money eventually becomes necessary to fund currency interventions. In the meantime, over the longer term the SNB could (and should) gradually lower its EUR/CHF “pain threshold” in view of the inflation differentials that are expected to persist in the future, because the continual accumulation of risk on the SNB’s balance sheet is ever less justified as time goes on. The SNB nonetheless now appears to have intervened once more on the currency market after the EUR/CHF exchange rate in recent days plummeted with forceful momentum to a new year-to-date low below the 1.07 mark. But if the SNB’s appetite for intervention subsides in the near future, the franc could take aim at parity against the euro likely sooner rather than later, to the surprise of many. Given the underlying fundamentals, such a development wouldn’t be crazy at all in any event.

 

Oliver Hackel, CFA Senior Investment Strategist

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