CHF: 2007 Rewind

Although 2007 showed some surprises, our expectation for broad CHF weakness, mainly against the EUR, turned out to be correct. EUR/CHF mostly led to effective (trade weighted basis) CHF weakness. This happened despite the risk-reduction episodes we saw in February and August, and most recently as well. Over the year, however, and somewhat surprising to us, domestic fundamentals have failed to play any significant role in driving the CHF.

CHF as a Funding Currency…
The CHF continued to operate as a funding currency throughout 2007. Indeed, we embraced the widely acknowledged idea that “carry trades” were most likely an important source of weakness for the CHF.

…But Not Only
In February, we suggested the following: First, “With the emergence of the GBP and EUR as reserve managers’ favorite currencies in recent years, both the JPY and CHF have been crowded out somewhat”. Second, and somewhat related: “There are signs that the CHF may have lost some of its shine as a safe-haven currency in recent years….The hypothesis that the rise of the EUR as a counter-weight to the dollar may have ‘crowded out’ the role of the CHF as an ‘alternative’ currency is one we find persuasive”.

CHF Driven Mainly by External Factors

The CHF behaved almost as if domestic developments were irrelevant to the currency. Despite the EUR/CHF being considerably overvalued according our Fair Value metric, we observed little role for Swiss fundamentals (this has surprised the SNB, as well). Accordingly, external developments have played a major role in driving the CHF throughout the year. However, on some occasions, the SNB played a role in managing currency market expectations through its policy stance (we note mid-June in particular where the SNB’s Roth made bullish comments that triggered a mini rally in CHF). In March, we said: “… US investors could hedge the increased risk of a consumption slowdown by buying CHF. In the coming months, the CHF could still prove resilient against the USD, despite the interest rate differential. As the dust settles on US growth concerns, and because it would no longer provide such a hedge, the CHF could struggle again.”

While this turned out to be correct, we failed to pin down how the resumption of US growth concerns would keep the CHF supported in Q3 as well. In October, we changed our call in light of changing financial and economic conditions (both domestically and globally). In the midst of the US economic slowdown, we suggested that loose Swiss monetary conditions and past exchange rate weakness would provide a cushion for the Swiss economy (which was still performing well). Also, the heightened financial risks surrounding the credit turmoil would add positives to the CHF. In summary, we argued: “We expect the CHF to remain supported against late cycle economies, with the benefit of closing interest rate gaps. Moreover, the tables may turn against EUR/CHF, as well. But for this to happen on a more sustained basis, we think the SNB will need to follow words with deeds in mid-December.”

While this turned out to be correct for GBP/CHF and USD/CHF, we saw only a moderate decline in EUR/CHF. As was widely anticipated by the market, the SNB decided to maintain rates on hold recently. (We had expected the SNB to raise rates at this meeting despite global uncertainty, mainly because of renewed acceleration in growth and inflation, but also because of the normalized Swiss money market and the opportunity to raise rates before any eventual economic slowdown, so as to benefit from a higher level of interest rate in case these needed to be lowered). Finally, and to follow up on this call, in November we published a note suggesting to again use the slowing US consumption as a good opportunity to build short USD/CHF positions. While this turned out to be a positive call as the CHF broke records against the USD (reaching 1.09), the last three weeks turned into broad-based USD strength, including against the CHF. This move is likely the result (at least in part) of position squaring and profit taking. Going forward, we would expect the CHF to perform again against the USD, as the “US consumption” play described above is still relevant. We will have a full 2008 outlook for the CHF in our next FX Pulse publication.

By Luca Bindelli London
Morgan Stanley
December 16, 2007