The strong Swiss franc has come to stay

The COVID-19 coronavirus is causing turmoil not just on the equity and fixed-income markets; currency volatility has also picked up considerably in recent weeks. The increasing likelihood of further policy rate cuts by the US Federal Reserve signifies a near-term headwind for the US dollar. The Swiss franc once again remains solid as a rock at the moment in the turbulent waters, and the appreciation pressure on the currency looks set to persist for quite some time to come.

Turmoil also on the currency market

There appears to be no escape from COVID-19, not even on the financial markets. The world equity market has nosedived by 12% from its previous record-high level, the yield on 10-year US Treasury notes has dropped to a new all-time below 1.1%, and general market volatility has increased significantly. But the coronavirus has also left its mark on currencies: the US dollar index has given up most of its year-to-date gains. Conversely, the euro has appreciated by 3% against the greenback in the span of just a couple of days.

US dollar index gives back its recent gains
Interest-rate cuts signify a headwind

US dollar index (DXY)

The prospect of a further easing of monetary policy by the US Federal Reserve is the primary cause of the sharp turnaround taken by the EUR/USD currency pair. Last Friday, Fed Chairman Jerome Powell pledged that the central bank would do everything in its power to support the US economy. For market participants, this means nothing other than more policy rate cuts. Futures markets in the meantime are already pricing in four quarter-point rate cuts by the end of this year and assign high odds to a 50-basis-point reduction as early as March 18. Further interest-rate cuts would make the US dollar much less attractive for carry trades. A carry trade is an investment strategy by which traders attempt to earn a profit on the interest-rate differential between two currencies, like between the euro and the US dollar for example. Given its current deposit rate of –0.50%, the European Central Bank (ECB), unlike the Fed, hardly has any leeway left to further lower interest rates. The interest-rate differential between the USA and the Eurozone can therefore really only tighten going forward.

The impact of the coronavirus could very well push the Eurozone economy to the brink of a recession.

Yet despite this assessment of the monetary policy situation, we do not see massive downside potential for the greenback against the euro because the impact of the coronavirus could very well push the Eurozone economy to the brink of a recession. As a cyclical currency, the euro needs better economic growth prospects to appreciate sustainably. We therefore consider the euro’s recent rally to be mostly a technical retracement of the currency’s previous price declines. This appraisal is also backed by our internal quantitative models, which see the euro weakening slightly against the US dollar over the next three months as well as on a twelve-month horizon. We think it would take a marked improvement in the macroeconomic climate and the formation of a solid floor on the price chart to bring about a sustainable trend reversal.

One-way street?
EUR/CHF exchange rate at 3-year low

EUR/CHF exchange rate

The SNB has a “problem”…

Speaking of price charts, the one for the EUR/CHF currency pair also doesn’t look particularly uplifting at present. In the face of the virus-induced financial market turbulence, the Swiss franc has flexed its muscles in recent weeks, gaining around 2.5% against the euro year-to-date. The current EUR/CHF exchange rate of close to 1.06 hasn’t been this low since three years ago. At that time, this exchange-rate level marked the starting point of a dynamic price surge. Normally in this spot, one could expect a major technical retracement rally to ensue for the time being. But nothing about the relationship between the franc and the euro has been normal for a long time now.

The strong franc has repeatedly caused headaches for the Swiss National Bank (SNB) in recent years. Time and again, the SNB has had to pull billions out of its coffers to bolster the euro, invariably for the objective of preventing Switzerland’s economy from slipping into deflation. Although higher productivity and lower inflation relative to the Eurozone theoretically justify a strengthening franc over the long term and companies in Switzerland are accustomed to the franc’s constant appreciation tendency, the top priority of the SNB’s money policy mandate is to maintain price stability. Last but not least, the SNB continues to consider the franc overvalued. Currency-market interventions therefore have consistently been the SNB’s tool of first resort in recent years. As a result of this, the assets on its balance sheet have swollen in the meantime to more than 120% of Switzerland’s gross domestic product (GDP). At the start of this year, an additional “problem” popped up for the SNB in the person of Donald Trump and the US Treasury Department. Specifically, Switzerland has again attracted negative attention in the Treasury Department’s latest report on the economic and currency policies of the USA’s 20 biggest trade partners, coming on the heels of having just been removed from Treasury’s watch list after its previous analysis in May 2019. With a current account surplus equal to 10.7% of GDP and with a USD 21.8 billion bilateral trade-in-goods surplus with the USA, Switzerland once again meets two of the three criteria that the Americans adduce as evidence of currency manipulation. The third criterion is currency-market interventions exceeding a total of 2% of GDP over a 12-month period. For Switzerland, that 2% cap would currently equate to an annual intervention volume of around CHF 14 billion.

Powder already shot
Major obstacles to further SNB interventions

1-week change in SNB sight deposits (in CHF millions)

…and limited ammunition

And this is precisely where maneuvering room could become cramped for the SNB. After largely staying inactive for more than a year from mid-2017 to beyond mid-2018, last summer the SNB was compelled to resume intervening on the currency market to weaken the franc. In the process, it already shot most of its powder available up to the aforementioned 2% cap. The SNB has recently drawn even closer to that limit. Commercial banks’ sight deposits at the central bank have steadily increased in recent weeks, indicating renewed intervention activity by the SNB, albeit in a smaller magnitude than in August of last year. The SNB now would soon have to refrain from further interventions at least until this coming summer if it doesn’t want to risk angering the Trump administration. Although there aren’t any automatic triggers that prompt the United States to label a country a currency manipulator, constant emphatic reiteration by the SNB that its currency-market interventions first and foremost serve the objective of maintaining price stability won’t suffice to avert that from happening. The SNB is thus bound to have little appetite for further currency interventions for the time being, or it at least seems unlikely that it will completely ignore the signals coming from US officials. This means that the Swiss franc may soon be left largely to the mercy of market forces, which for years now have all been pointing in the same direction: upward. And the reason for that is since interest-rate spreads between Switzerland and the rest of the world shrunk to marginal differentials in the wake of the financial crisis, Switzerland’s huge current account surplus has since been insufficiently counterpoised by capital outflows. This has produced continual appreciation pressure that sooner or later looks destined to lift the franc back toward parity against the euro in the years ahead.