Thanos Papasavvas - is Head of Currency Management at Investec Asset Management

The Swiss Franc - where to now?

Thanos Papasavvas - is Head of Currency Management at Investec Asset Management

Recent measures taken by the Swiss National Bank (SNB) to peg the franc to the euro have been widely debated. In our view, the measure is bold, but reasonable and understandable, and we believe the SNB will succeed in maintaining the EUR/CHF above 1.2000. However, these developments also raise a number of questions: first, what led to this action and ultimately this decision being made by the SNB; secondly, where is the Swiss franc likely to move now, and finally, where will investors choose to invest now that the franc no longer expresses an isolated safe-haven currency?

Over-extended appreciation

In our view, leading up to this action, the Swiss franc had over-extended its appreciation to become one of the most expensive currencies in the world. The ongoing debacle in the euro zone, US structural issues and the overall uncertainty surrounding the global economic environment following the financial crisis had led investors over the past few years to buy Swiss francs alongside gold as a safe haven. As a result the franc has appreciated by 40% against the euro, 45% against the US dollar and 54% against the British pound when compared to its pre-financial crisis levels. Even year to date to the end of August the Swiss franc was also the world's strongest currency, up 16% against the US dollar.

These large price movements not only had an adverse impact on the competitiveness of the Swiss corporate sector, but also prevented the SNB from enacting an independent monetary policy. This was because in the current low yield environment any rise in interest rates in Switzerland would be met with further inflows into the franc, triggering even more currency appreciation. The SNB has made several attempts to stem this appreciation on a number of occasions over the past year. The ad-hoc interventions proved not only to be costly in monetary and political terms but also damaging to the credibility of the SNB.

Successful intervention

We believe interventions can be successful if they have a strong fundamental rationale and are concerted at a G7 level. Alternatively, if the intervention is unilateral as is the case with the SNB, then the central bank in question must have ample credibility and the necessary funds to take on the market should it be required.

The latter point is more important in times of stemming currency weakness as central banks have to use foreign reserves, whereas in stemming currency appreciation the central bank can in theory print 'unlimited' quantities of local currency to sell - which in itself has the adverse impact of creating inflation. The last major test of the credibility of the SNB was in 1978 when it successfully managed to adopt a target against the Deutsche Mark to avoid further appreciation.

To consider the level of the franc moving forward, we first need to see where it came from and why. Looking back at the period prior to the recent financial crisis, when investors searched for yield in a low volatility environment, the franc was used as a funding currency for carry-trades. As a result it gradually weakened to EUR/CHF 1.6847 by the end of October 2007. Following the financial crisis, however, when carry positions were unwound and investors sold overvalued currencies such as the Australian and New Zealand dollars to buy back their shorts in yen and franc, the franc appreciated to EUR/CHF1.5000 where it range traded until November of 2009.

It is worth noting that the franc's appreciation was muted during the financial crisis when compared to the yen and the US dollar. This was because the Swiss economy had a heavy dependence on the banking sector and as an open economy was closely linked to the global economic environment.

The more recent move from EUR/CHF 1.5000 in November 2009 to EUR/CHF 1.0075 in August 2011 has been partly due to the euro debacle and partly due to the overall weakness of the US dollar given the economic, fiscal and political concerns surrounding the US. The easy question is "What would take the franc back to EUR/CHF 1.4000?". We believe the answer is some type of resolution to the current euro-zone issues. The hard question is "When?" This we do not know, but we do believe that EU policy makers will do whatever is necessary to ensure the sustainability of the single currency, even if this takes a little longer than markets expect.

Future safe-havens

Finally, now that the franc no longer expresses an isolated safe-haven currency, where will investors choose to invest, and will the measures have consequences for the bond market? In answering this, we have already seen the Norwegian krone appreciating and yields falling as a result of a proxy to the franc within Europe. We have maintained our underweight exposure to the franc partly due to the excessive valuations which made it amongst the most expensive currencies in the world, but also due to our belief that the market was too bearish on both the global economic scenario going forward and the outlook for the euro zone. The franc may no longer represent an isolated safe-haven currency at its current levels against the euro, but we have always held a well diversified portfolio of currencies both in the major and emerging market world to represent that view. In fact, in many ways the emerging market currencies have been the major beneficiaries of the recent crises as their fiscal prudence, monetary discipline and political transparency have led the asset class to become a structural rather than a cyclical story.

"The ad-hoc interventions proved not only to be costly in monetary and political terms but also damaging to the credibility of the SNB."

It is also important to note that when the SNB intervenes against the markets it will need to invest the foreign currencies purchased into their respective denominated issues. Although the majority of interventions will be enacted in EUR/CHF, we do not exclude the purchase of US dollars as and when appropriate. The euros which are bought would have to be gradually redistributed to the currency allocation of the reserves at that point in time. For example, as at the end of June the currency allocation of the SNB reserves was 55% EUR, 25% USD, 10% JPY, 4% CAD, 3% GBP and 3% Other (AUD, SEK, DKK and SGD).

The allocation is dynamically managed, with the portion of reserves denominated in euros rising substantially as interventions took place over 2009-10, but then returning to more normal levels as the SNB re-balanced over time. As for its physical holdings, 84% are Government bonds, 10% Shares and 6% Other bonds. The structure of the bonds are 83% AAA, 14% AA, 1% A and 2% Other.

The guidelines of the SNB restrict it to investing in issuers with a combined investment grade rating from the leading rating agencies. Would they choose to invest some of the euros in peripheral bonds? We do not think they would until there are signs of stability and resolution; security, liquidity and returns are what drive the SNB investment process.