Chapter 29
Currency Profile: Swiss Franc (CHF)

Broad Economic Overview

Switzerland is the twentieth largest economy in the world, with a GDP valued at over US$685 billion as of 2014. Although the economy is relatively small, it is one of the wealthiest in the world on a GDP per capita basis. The country is prosperous and technologically advanced with economic and political stability that rivals many larger economies. The country's prosperity stems primarily from technological expertise in manufacturing, tourism, and banking. More specifically, Switzerland is known for their chemicals and pharmaceuticals industries, machinery, precision instruments, watches, and a financial system historically known for protecting the confidentiality of its investors. This coupled with the country's lengthy history of political neutrality earned Switzerland the Swiss franc safe haven status and as a direct result of that, it is the one world's most popular destinations for offshore capital. Even when the central bank introduced a temporary 1.20 EURCHF peg and lowered interest rates to negative levels, Switzerland still managed to attract safe haven flows.

It is estimated that Switzerland holds over US$2 trillion in offshore assets as of 2014 and attracts over 35% of the world's private wealth management business. A large and highly advanced banking and insurance industry has developed to support this demand, and the sector employs over 50% of the population and comprises over 70% of total GDP. Since Switzerland's financial industry thrives on its safe haven status and renowned confidentiality, capital flows tend to drive the economy during times of global risk aversion, while trade flows drive the economy in a risk-seeking environment. Trade flows are extremely important, with nearly two thirds of all trade conducted with Europe. With this in mind, Switzerland's most important trading partners are the following:

Leading Export Markets

1. Germany
2. India
3. United States
4. Hong Kong
5. France

Leading Import Sources

1. Germany
2. Italy
3. United States
4. France
5. China

Traditionally, Switzerland has a strong trade and current account surplus that lends support to the currency. Most of the surplus can be attributed to the large amount of foreign direct investment into the country, in seek of safety of capital, despite the low to negative yields offered by Switzerland.

Monetary and Fiscal Policy Makers— Swiss National Bank

Monetary policy in Switzerland is determined by the Swiss National Bank (SNB). They are a completely independent authority with a three-person committee responsible for determining monetary policy. This committee consists of a chairman, a vice chairman, and one other (member) who constitute the Governing Board of the SNB. Due to the small size of the committee, all decisions are based on a consensus vote. The Board reviews monetary policy at least once a quarter, but decisions on monetary policy can be made and announced at any point in time. Unlike most other central banks, the SNB does not set one official interest rate target, but instead sets a target range for their three-month Swiss Libor rate.

Central Bank's Goals

In December of 1999, the SNB shifted from focusing on monetary targets (M3) to an inflation target of less than 2% inflation per year. This measure is taken based on the national consumer price index. Monetary targets still remain important indicators and are closely watched by the central bank, because they provide information on the long-term inflation. This new inflation focus also increases the central bank's transparency. In their mandate, they have clearly stated, “Should inflation exceed 2% in the medium term, the National Bank will tend to tighten its monetary stance.” If there is danger of deflation, the National Bank would loosen monetary policy. The SNB also closely monitors exchange rates, as excessive strength in the Swiss franc can cause inflationary conditions. This is especially true in environments of global risk aversion, as capital flows into Switzerland increases significantly during those times. As a result, the SNB typically favors a weak franc, and is not hesitant to use intervention as liquidity tool. SNB officials intervene in the franc using a variety of methods including verbal remarks on liquidity, money supply, and the currency.

Their Tools

The most commonly used tools by the SNB to implement monetary policy include the following.

Target Interest Rate Range

Traditionally, the SNB implements monetary policy by setting a target range for their three-month interest rate known as the Swiss Franc Libor rate. According to the SNB, “The Libor is a reference interest rate in the interbank market for unsecured loans.” It is a trimmed mean of the rates charged by 12 leading banks and is published daily by the British Bankers' Association. The National Bank publishes its target range regularly. As a rule, this range extends over 1 percentage point, and the SNB generally aims to keep the Libor in the middle of the range. The SNB undertakes quarterly economic and monetary assessments at which it reviews its monetary policy. If circumstances so require, it will also adjust the Libor target range in between these quarterly assessments. It sets out the reasons for its decisions in press releases.

Open Market Operations

Repo transactions are the SNB's major monetary policy instrument. A repo transaction involves a cash taker (borrower) selling securities to a cash provider (lender), while agreeing to repurchase the securities of the same type and quantity at a later date. This structure is similar to a secured loan, whereby the cash taker must pay the cash provider interest. These repo transactions tend to have very short maturities ranging from one day to a few weeks. The SNB uses these repo transactions to manipulate undesirable moves in the three-month Libor rate. To prevent increases in the three-month Libor rate above the SNB's target, the bank would supply the commercial banks with additional liquidity through repo transactions at lower repo rates, and in essence create additional liquidity. Conversely, the SNB can reduce liquidity or induce increases in the three-month Libor rate by increasing repo rates.

In addition to the quarterly monetary policy decision, the SNB publishes a Quarterly Bulletin with a detailed assessment of the current state of the economy and a review of monetary policy. A Monthly Bulletin is also published containing a short review of economic developments. These reports are important to watch, as they may contain information on changes in the SNB's assessment of economy and guidance on monetary policy.

1.20 EUR/CHF Peg Implementation and Abandonment

Few would have expected that one of the seminal developments in the forex market was the Swiss National Bank's decision to implement and later abandon its 1.20 EURCHF peg. This decision transformed the foreign exchange industry, bankrupted many brokers, and led to tighter regulations across the globe. Faced with a high level of uncertainty in the financial markets, an overvalued currency and deflation risks in 2011, the SNB introduced a minimum exchange rate of CHF 1.20 per euro. At the time, it pledged to sell francs in an unlimited quantity to maintain the peg. The goal was to stabilize the Swiss economy by capping the gain in the franc. However, in January 2015, the prospect of quantitative easing from the European Central Bank pushed the SNB to abandon the peg. It also accumulated significant foreign exchange reserves that irritated critics, but more importantly, the franc became less overvalued through the years, giving the SNB fewer reasons to maintain the peg. SNB's decision was a complete surprise, and caused a 30% drop in EURCHF in a single day. Many foreign exchange brokers were unprepared for the move and experienced massive losses as a result.

Important Characteristics of the Swiss Franc

• Safe haven status. This is perhaps the most unique characteristic of the Swiss franc. Switzerland's safe haven status is continually stressed because this and the secrecy of the banking system are the key advantages of Switzerland. The Swiss franc moves primarily on external events rather than domestic economic conditions. That is, as mentioned earlier, due to its political neutrality, the franc is considered the world's premier safe haven currency. Therefore, in times of global instability and/or uncertainty, investors tend to be more concerned with capital retention than appreciation. At such times, funds will flow into Switzerland, which would cause the Swiss franc to appreciate regardless of whether growth conditions are favorable.
• Swiss franc is closely correlated with gold. Switzerland is the world's third largest official holder of gold. In the past, a Swiss constitutional mandate required the currency to be backed 40% with gold reserves. The mandate is now removed but the positive correlation between the Swiss franc and gold remains because the relationship has been engrained into the minds of forex traders; therefore, both gold and the Swiss franc are perceived as safe haven instruments. Before the SNB abandoned the EURCHF 1.20, Swiss franc had an 80% positive correlation with gold. These days, the correlation is still there but in a smaller magnitude. Generally speaking, if the price of gold appreciates, the Swiss franc has a high likelihood of rising in value. In addition, since gold is also viewed as the ultimate safe haven form of money, both gold and the Swiss franc benefit during periods of global economic and geopolitical uncertainty.
• Carry trades effects. With one of the lowest interest rates in the industrialized world, over the past few years, the Swiss franc has become one of the most popular funding currencies for carry trades. As mentioned in this book, the popularity of carry trades has increased significantly over the past two decades, as investors are actively seeking high yield. A carry trade involves buying or lending a currency with a high interest rate and selling or borrowing a currency with a low interest rate. With CHF having one of the lowest interest rates of all industrialized countries, it is one of the primary currencies sold or borrowed in carry trades. This results in the need to sell CHF against a higher yielding currency. Carry trades are typically done in cross-currencies such as GBPCHF or AUDCHF, but these trades can impact both EURCHF and USDCHF. The unwinding of carry trades involves the need for investors to buy back the Swiss franc.
• Interest rate differentials between euro Swiss futures and foreign interest rate futures are closely followed. One of the favorite indicators of professional Swiss franc traders is the interest rate differential between three-month euro Swiss futures and eurodollar futures. These differentials can provide guidance on potential money flows as they indicate how much premium yield U.S. fixed-income assets are offering over Swiss fixed-income assets, or vice versa. This differential provides traders with indications of potential currency movements, as investors are always looking for assets with the highest yields. This is particularly important to carry traders who enter and exit their positions based on the positive interest rate differentials between global fixed-income assets.
• Potential changes in banking regulations. Over the past few years members of the European Union have been exerting significant pressure on Switzerland to relax the confidentiality of their banking system and to increase transparency of their customers' accounts. The European Union is pressing this issue because of its active measures to persecute EU tax evaders. This should be a concern for many years to come. However, this is a difficult decision for Switzerland to make because the confidentiality of their customers' accounts represents the core strength of their banking system. The EU has threatened to impose severe sanctions on Switzerland if they do not comply with their proposed measures. Both countries are currently working to negotiate an equitable resolution. Any news or talk of changing banking regulations will impact both Switzerland's economy and the Swiss franc.
• Mergers and acquisition activity. Switzerland's primary industry is banking and finance. In this industry, merger and acquisition activities (M&A) are very common, especially as consolidation continues in the overall industry. As a result, these M&A activities can have significant impact on the Swiss franc. If foreign firms purchase Swiss banks or insurance companies, they will need to buy Swiss francs and in turn, sell their local currency. If Swiss banks purchase foreign firms, they would need to sell Swiss francs and buy the foreign currency. Either way, it is important for Swiss franc traders to frequently watch for notices on M&A activity involving Swiss firms.
• Trading behavior, cross currency characteristics. The EURCHF is the most commonly traded currency for traders who want to participate in CHF movements. USDCHF is less frequently traded because of its greater illiquidity and volatility. However, day traders may tend to favor USDCHF over EURCHF because of its volatile movements. In actuality, the USDCHF is a synthetic currency derived from EURUSD and EURCHF because more transactions are done between the euro and Swiss franc. Market makers or professional traders tend to use those pairs as leading indicators for trading USDCHF or to price the current USDCHF level when the currency pair is illiquid. Theoretically, the USDCHF rate should be exactly equal to the EURCHF rate divided by EURUSD. Only during times of unusual circumstances, such as the Iraq War, September 11, or the EURCHF peg, will USDCHF develop a market of its own. Any small differences in these rates are quickly exploited by market participants. Figure 29.1 highlights the 10 year performance of EUR-CHF.

Figure 29.1 EURCHF 10-Year Chart

Source: eSignal

Important Economic Indicators for Switzerland

Economic data from Switzerland tends to have limited impact on the currency, but these are the most important pieces of Swiss data.

KoF Leading Indicators

The KoF leading indicators report is released by the Swiss Institute for Business Cycle Research. This index is generally used to gauge the future health of the Swiss economy. It contains six components: (1) change in manufacturers' orders; (2) the expected purchase plans of manufacturers over the next three months; (3) the judgment of stocks in wholesale business; (4) consumer perception of their financial conditions; (5) backlog in the construction sector; and (6) orders backlog for manufacturers.

Consumer Price Index

The Consumer Price Index is calculated monthly, on the basis of retail prices paid in Switzerland. In accordance with prevalent international practice, the commodities covered are distinguished according to the consumption concept, which includes in the calculation of the CPI of those goods and services that are part of the private consumption aggregate according to the National Accounts. The basket of goods does not include transfer expenditure such as direct taxation, social insurance contributions, and health insurance premiums. The index is a key measure of inflation.

Gross Domestic Product

GDP is a measure of the total production and consumption of goods and services in the Switzerland. GDP is measured by adding expenditures by households, businesses, government, and net foreign purchases. The GDP price deflator is used to convert output measured at current prices into constant-dollar GDP. The data are used to gauge where in the business cycle Switzerland finds itself. Fast growth often is perceived as inflationary, while low (or negative) growth indicates a recessionary or weak growth period.

Balance of Payments

Balance of payments is the collective term for the accounts of Swiss transactions with the rest of the world. The current account is the balance of trade plus services portion. BoP is an important indicator for Swiss traders, as Switzerland has always kept a strong current account balance. Any changes to the current account, positive or negative, could see substantial flows.

Production Index (Industrial Production)

The production index is a quarterly measure of the change in the volume of industrial production (or physical output by producers).

Retail Sales

Switzerland's retail sales report is released on a monthly basis 40 days after the reference month. The report is an important indicator of consumer spending habits and is not seasonally adjusted.