USD/CHF Third Quarter FX Outlook

The Swiss franc has been trading in a relatively tight range against the US dollar throughout the first half of 2007.

Yet, over the last four weeks, market conditions seem to have changed and the franc staged an impressive recovery against the US dollar on speculation that the Swiss National Bank (SNB) could accelerate the pace of monetary policy tightening to fight inflation. The franc gained nearly 4 percent against the US dollar, trading from a high of 1.2476 on June 14th to a low of 1.1992 on July 11th. However, Switzerland’s key interest rate is still among the lowest in the world and because of that, the franc has been particularly weak against other higher yielding currencies like the sterling and euro. More specifically, since April 1st the franc lost 2.4 percent against the euro and roughly 2.5 percent against the British pound. Currently, Switzerland 10 year government bonds yield 135 basis points less than their German counterparts and 212 bps less than UK Gilts.
[B]The Swiss economy is performing better than expected[/B]
The Swiss economy is very healthy and performing better than expected, according to the last Monetary Policy Report released by the Swiss National Bank on June 14. The SNB revised its GDP forecast upwards and now expects real GDP to grow at a rate close to 2.5% in 2007 and an average annual inflation rate of 0.8% in 2007, 1.5% in 2008, and 1.7% in 2009. When the SNB published its March quarterly report, the central bank expected real GDP to grow at a rate of close to just 2% and an average annual inflation rate of 0.5% in 2007, 1.4% in 2008 and 1.6% in 2009. In fact, the Swiss economy is showing few signs of cooling as the alpine economy continues enjoying the benefits of healthy demand in both domestic markets and foreign markets. According to the KOF survey, which is Switzerland’s version of leading indicators or a monthly aggregate of indicators that aims to predict the direction of the Swiss economy six months forward, rose to the highest level in nine months in June, suggesting the economy will gain more speed in the second half of the year. The healthy economic environment is also being reflected in the labor market. The Swiss unemployment rate declined in June to 2.7 percent, the lowest in almost five years as companies increased hiring to meet orders.
[B]No More Quotas for foreign workers from the European Union[/B]
A very tight labor market has long been a characteristic of the Swiss economy. Yet, this is about to change. As of June 1 2007, the quotas for working permits granted to foreign workers from the European Union as well as Cyprus and Malta were abolished and the regulations for cross border commuters were relaxed further. Swiss companies have been increasingly worried about manpower shortages holding back production and this opening of the job market is expected to lead to greater hiring flexibility and less pressure on salaries.
[B]The SNB could be poised to raise rates two more times in 2007[/B]
In a widely expected move, the Swiss National Bank raised the target range for the three-month Libor by 0.25 percentage points to 2.00-3.00%, at its quarterly assessment in June. The SNB President Jean-Pierre Roth also said the central bank “won’t hesitate’” to raise interest rates further if necessary and more interest rate hikes are likely in the second half of 2007 to prevent an expanding economy and a weaker franc from creating inflation. The SNB is worried that higher oil costs will translate into higher production costs, which could in turn lead to elevated consumer prices. Indeed, consumer prices rose 0.6 percent in June led by higher costs for tobacco, apartments and energy. Therefore, given the high level of capacity utilization in the Swiss economy, despite seven increases in the benchmark interest rate since late 2005, the central bank could be poised to raise rates two more times in this year.
[B]The Swiss franc dropped to a record low against the euro[/B]
During the second quarter, the Swiss franc dropped to a record low against the euro on speculation the European Central Bank will increase rates more rapidly than the Swiss National Bank. The ECB President Jean-Claude has been clearly more hawkish than SNB?s Jean-Pierre Roth with the ECB raising rates 3 times this year versus only two rate hikes from the SNB. This divergence in sentiment has resulted in euro strength. In the last 6 months, the euro gained nearly 3.4 percent against the Swiss franc, trading from a January low of 1.6120 to an all time high of 1.6669 reached last June. On the one hand, a drop in the value of the Swiss franc has been good for Swiss economy boosting exports by making Swiss goods more competitive abroad. On the other hand, a weak franc makes the Swiss economy more vulnerable to a surge in international energy and commodity prices.
In the third quarter of 2007, the Swiss National Bank is likely to continue normalizing its key interest rate in order to guarantee price stability. The additional monetary tightening could provide further support to the Swiss franc. According to the interest rate futures for deposits denominated in Swiss francs, traders are clearly pricing two more rate hikes in 2007. While the overnight interest rate pays 2.03 percent, the 3 month rate pays 2.73 percent, the 1 year rate 3.10 percent and the 10 year more than 3.69 percent. Also, higher interest rates in Switzerland should make the Swiss franc less attractive as a funding currency against higher yielding currencies and put additional carry trade pressure in the Japanese yen. Based upon these dynamics, we expect the Franc to gain strength in the second half of the year.
[B]Technical Outlook[/B]
The USDCHF has traded sideways for the past 3 months but continues to hold above the December 2006 low of 1.1877. The decline from the February high of 1.2571 is still corrective (3 waves), therefore upside potential remains. The bullish count has 1.1877 as the bottom of a B wave within an A-B-C correction that began at the December 2004 low of 1.1286. If this count is correct, then wave C is expected to eventually exceed 1.3285. A rally through 1.2786 bolsters the bullish outlook. Until then, it remains possible that a triangle is unfolding from the May 2006 low at 1.1920. In this instance, a thrust below 1.1877 would occur soon and test the 78.6% of 1.1286-1.3285 at 1.1714 and likely lower levels. This is now the favored count and is shown on the chart.
[B]USDCHF Daily Chart (Source: TradeStation 8.2)[/B]