The Swiss Franc outperformed all other G10 currencies against the US dollar in the first quarter of this year, gaining nearly the 15% on the troubled Greenback. By comparison, the Euro gained just over 9%. This remarkable rally was driven by a broad-based flight to quality away from risk and in search of a safe haven from the US recession.
Additionally, Switzerland’s exposure to the United States is substantially smaller than most other G10 countries. While Japan and the Euro Zone depend on the US for a large portion of their export market, Switzerland ranks 18th among US foreign trade partners by volume. For Switzerland, US trade only accounts for 10 percent of total exports. This means that a slowdown in US growth and subsequent decline in American consumers’ appetite for imported goods has less of an effect on Swiss import firms. This relative isolation made Switzerland and by extension the Franc an attractive store-of-value destination for shell-shocked investors looking to weather US-led market woes.
[B]Most Swiss Fundamentals Turning Lower, Consumption Sending Mixed Signals[/B]
[B]
[/B]Looking past the first quarter, Switzerland will not go unscathed in the current global downturn. As the subprime crisis began to unfold, many entertained the “de-coupling” hypothesis that suggested a US recession will not drag down global growth as lagging American demand is replaced with robust consumption in other markets. Proponents of this idea pointed to resilient Japanese and European trade figures, suggesting de-coupling had materialized because export growth had remained strong all the while the US suffered and the dollar fell. Most recent economic data has not been supportive of this view. In particular, Euro zone fundamentals have turned significantly lower, with major deterioration in consumption and trade indicators. While the US accounts for only 10% of Swiss trade flows, the EU accounts for over 60%. This makes Switzerland highly sensitive to a slowdown there. Echoing this sentiment, The government’s State Secretariat for Economic Affairs (SECO) noted ominously in their most recent survey of the economy that the “international financial crisis represents a considerable and difficult-to-quantify risk to the economy”.
The most recent data is already beginning to show signs of slowdown, with the KOF Leading Indicator index printing at a 2-year low in March. The SVME-Purchasing Manager’s Index has declined as well, showing business confidence dropping -8.6% and inching lower to the “boom-bust” 50 level to print at 55.3 in March. While Q4 GDP remained resilient, these figures are too backward-looking to be indicative at this point and the readings for the first quarter will likely show a contraction. Though the latest trade figures have stayed largely positive, the expression of a slowdown in these numbers tends to be lagging because import/export firms negotiate contract terms months ahead of an actual transaction. This means we may see significant deterioration in Swiss trade metrics going forward.
Private consumption indicators present a mixed result. January’s Retail Sales figure showed a modest 1.3% expansion. On balance, February’s UBS Consumption Indicator reading was overwhelmingly positive, sending the metric to an 8-month high. Unemployment has been declining steadily, meaning Swiss consumers are enjoying greater levels of disposable income. Should this translate into sales going forward, the domestic market may turn out to be the pillar that holds up the economy as pressure from global economic headwinds intensifies.
[B]SNB Keeps Interest Rates on Hold as Inflation Pushes Higher[/B]
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[/B]Switzerland’s central bank has taken stock of the economies inability to remain impervious to global slowdown. Jean-Pierre Roth and company opted to keep rates on hold for the second time at their March 13th meeting after eight consecutive hikes beginning in 2005. The SNB assessment that followed the decision revealed that the bank was viewing the current economic landscape with “a great deal of uncertainty”. Official estimates for this year’s economic growth were trimmed to 1.5% form 2%. The infrequent schedule of Swiss monetary policy meetings and bank officials’ current rhetoric suggests that the SNB is planning to remain on the sidelines for an extended period.
Meanwhile, inflation has continued to tick up with CPI reaching 14-year highs in the past two months. The price level is being driven higher by buoyant commodity prices and the bidding up of wages due to a tighter labor market. Should inflation continue to push higher, the SNB will find it increasingly difficult to balance its posture between protecting economic growth and ensuring price stability. The bank supports its neutral posture with the assertion that slowing global growth will subdue inflation. And yet, the bank revised up its 2008 CPI projections in the same breath that it revised down those for GDP, pushing the metric out to 2% versus a previous estimate of 1.7%. Much could change before the SNB’s next policy meeting on June 19th, but if current trends continue along the same trajectory the bank will be forced to make some difficult decisions.
[B]Policy Symmetry and Risk Aversion Are Key Drivers of the EURCHF Exchange Rate [/B]
Last fall saw the beginning of what would amount to a massive correction in the EURCHF exchange rate. The Euro rallied steadily against the Franc since January of 2002 as the European Central Bank was easily discernable as more hawkish than its Swiss counterpart. As the SNB raised borrowing costs in September with the ECB firmly on hold at 4% since June, it became clear the yield gap would begin to be corrected. This laid the groundwork for a momentous rally in the Franc against the single currency, with EURCHF falling by nearly 10% by mid-March. Adding a further catalyst to the pair’s sharp decline in the first quarter was the pronounced presence of the influences of global trends in risk appetite in the EURCHF exchange rate. A comparison in the EURCHF exchange rate with a broad index tracking FX carry trades reveals a stark symmetry in recent price action.
Looking forward, the SNB has now been established as on hold. This should suggest that EURCHF needs to rebound higher to account for the new symmetry in monetary policy between Switzerland and the Euro area. Tellingly, the pair began to rebound just four days after the SNB announced they would keep borrowing costs in place at least until the summer. However, the correlation with global carry could upset the situation. Should another major bout of risk aversion sweep the market, the EURCHF will likely tumble lower once again.
[B]Key Points[/B]
Limited direct exposure to the US and a massive liquidation in carry trades has driven the Swiss Franc higher in the first quarter. However, the significant downturn in the Euro Zone has begun to transmit the effects of waning global growth to the Swiss economy. To address developing downside risks, the SNB has paused the process of normalizing interest rates and opted to remain on the sidelines for two consecutive quarters. All the same, price level pressure has remained elevated with oil reaching record highs and a continued tightening of conditions in the domestic labor market.
Going forward, we believe current trends will help to ease inflationary pressure as the US slowdown proves to be a drag on the global economy overall. This will give the SNB room sufficient room to keep interest rates unchanged for much of the year. Barring another sharp spike in risk aversion, this will lead to a divergence in the Franc’s performance versus the Euro and the US Dollar. Interest rates are now lower in the US than Switzerland. With the Fed intent on further rate cuts, the yield gap between the two countries is expected to widen, driving the USDCHF lower. The case of the EURCHF will be quite different. The unfolding slowdown in the Euro Zone will drag Switzerland along via the close trade relationship between the two markets. This transmission mechanism will erase much of the qualitative advantage of the Franc against the Euro as growth slows globally, leaving interest rate expectations to drive EURCHF. From this perspective, we see the need for a correction higher as traders re-price the currency to account for both central banks now being on the sidelines. As we mentioned above, the ECB’s shift to neutral preceded that of the SNB, helping to push the EURCHF lower as the Swiss bank was projected to be more hawkish. Now that policies have been confirmed to be aligned, expectations should shift and force the CHF to return some of its earlier gains.
On balance, it is critical to stress that monetary policy and other fundamental considerations will be negated should another flare up in risk aversion spook the markets. In this scenario, the Franc will rally across currency pairs.
<strong><u>USD/CHF Technical Outlook</em>
We wrote in last quarter’s outlook that “a new low is expected in wave 5 (below 1.0886) before we can expect any kind of significant rally. An objective is 1.0616 (61.8% extension of wave 1 through 3).” The USDCHF made a new low but the decline was much larger than we had thought possible. Now, a 5 wave drop from the 2005 peak at 1.3285 appears complete or very close to complete. A slight new low is possible (below .9647) in order to complete wave 5 but the next big move will likely be towards the Fibonacci zone (38.2% to 61.8% of 1.3285-.9647) at 1.1037-1.1895.
