Et Tu, SNB?

‘A balanced perspective cannot be acquired by studying disciplines in pieces but through pursuit of the consilience among them.’

Edward O. Wilson

Summary

• The upcoming Swiss National Bank (SNB) monetary policy meeting provides an ideal vantage point to consider future Swiss monetary policy as driven by both domestic and global influences and provides significant trading opportunities.

Market Implications

• Recent CHF strength may fade as an SNB monetary policy shift combines with opportunities to exploit currency factor return premia in carry, value, and momentum.
• Interest rate expectations along the Swiss yield curve will likely remain anchored, driven by both monetary policy and domestic pension demand in longer-dated maturities.
• Swiss stocks with a large export component, such as Nestle (unchanged YTD), may benefit from CHF stability or weakness.

Introduction

As the strongest G10 currency in 2023, the Swiss franc (CHF) is overdue a pullback.

Ahead of the Swiss National Bank rate decision tomorrow, the CHF trade-weighted index (TWI) sits near a record high.  

While the SNB is expected to hike another 25 basis points (bp) in the coming months, with a strong likelihood that the move comes tomorrow, we look at the case for a reversal of CHF strength in the coming months.

Global Macro Backdrop

Developed market central banks have all pledged to maintain tight monetary policy until price stability is restored. Japan is a nuanced story. But even so, under Governor Ueda’s guidance, yield curve control has been tweaked higher for the first time since 2016.

A reasonable trader might wonder if central banks are suffering from recency bias, driven by their failure to anticipate the inflation spikes of 2022. As traders, we are paid to anticipate market direction and structure investments that provide positive asymmetric outcomes.

One does not need to look too far to see that the United States, Germany, and China all pose a challenge to the recently touted view of an economic ‘soft landing’. Together, these countries comprise close to 50% of global GDP, and the evidence suggests a ‘hard landing’ is more likely than markets have priced. 

In the United States, the San Francisco Fed expects expiring pandemic-era stimulus to be a significant risk to consumer spending, which makes up over 60% of aggregate demand.   On US inflation, the lags of the shelter component of CPI (40% of core CPI) should be a significant force pushing inflation to the Fed’s 2% target.

Germany, the largest economy in Europe, has just registered a third consecutive quarter of negative GDP growth as policy errors of reliance on exports to China and Russian energy come home to roost.

China’s credit-fuelled property market and export-led growth model problems have become more widely known. But what is not fully priced is the long-term economic malaise China is likely to suffer. Nor is the direct and indirect influence the world’s second largest economy and largest commodity importer will have on both growth, inflation, and capital flows globally.

Taken together, these factors suggest a significant impact on both growth and inflation trajectories that will greatly impact asset markets, including interest rates, currencies, equities, and commodities.

Swiss Macro Backdrop

Incorporating the broader global macroeconomic backdrop and idiosyncratic nature of the Swiss economy into an investment thesis leads to some interesting trades.

Tomorrow’s quarterly meeting of the SNB provides an opportunity to structure trades anticipating the SNB’s present and future views in conjunction with current market pricing and positioning dynamics.

The SNB’s monetary policy focuses on price stability, defined by a rise of Swiss CPI by less than 2% per annum. To adopt a forward-looking stance, the SNB publishes quarterly an inflation forecast for the following three years. Both the exchange rate and interest rate level are used to implement monetary policy.

In June 2022, the SNB unexpectedly raised rates by 50bps to -0.25%, the first hike since 2007. The SNB also emphasized that intervention in the currency markets through CHF purchases would be used to bring inflation down to target from 14-year highs of 2.9%.

At the most recent meeting in June 2023, the SNB raised rates for a fifth time, by 25bps to 1.75%, and signalled possible further hikes. The bank also lowered the inflation forecast to 2.2% for both 2023 and 2024.

On the path to the current interest rate regime, the highest since 2002, the SNB has deliberately attempted to be forward looking, actively adjusted inflation forecasts, and aggressively used the currency as a tool to tighten monetary policy.

For the SNB meeting tomorrow, 24 of 27 economists surveyed by Bloomberg expect a 25bp hike to 2.0%, and markets price a roughly 90% chance of +0.25% by the end of 2023.

A current assessment of Swiss macroeconomic indicators, likely forward path of SNB policy, market pricing, and positioning dynamics produces a variant perception relative to current market expectations and generates several trade opportunities.

Markets imply interest rates will stay low, or go lower, than expected, and the SNB may slow CHF currency intervention and reserve drawdowns, which would likely lead to stability or weakness in the Swiss Franc.

Conversely, possible risks leading to a higher CHF and interest rates may stem from safe haven flows driven by geopolitical uncertainty, the strong Swiss balance of payments, and continued upward pressure on inflation from factors such as energy costs, demographics, and clean energy.

Swiss Consumer Price Inflation (CPI)

Swiss CPI has undershot the 2% target for three months running, the SNB inflation forecast is likely to be moved lower again, and inflation is likely to be below target in the next few quarters.  Upside risks stem from base effects in the coming months and higher energy prices. SNB’s Vice Chairman Schlegel has also noted the medium-term risk to higher inflation driven by demographics and clean energy transition.

Swiss Gross Domestic Product (GDP)

Swiss GDP has been stagnating and the open Swiss economy is highly levered to global growth.

Exports are 75% of GDP (2022). And with over 30% going to Europe, 9% to China, and 14% to US (2021), the negative feedback mechanisms of a global slowdown are clear.

Swiss Real Effective Exchange Rate (REER)

The Swiss Franc Real Effective Exchange Rate has appreciated almost 5% since the beginning of 2023 and should act as a catalyst to reduce inflation.

An SNB study following the 2015 EURCHF 1.2 target floor removal concluded the relatively small and open Swiss economy experiences comparatively large and fast pass-through from currency to inflation.

Swiss FX Reserves

Swiss FX reserves have continued to fall as the SNB shrinks the balance sheet and purchases CHF to tighten policy. Reserves have fallen about 27% since peaking in late 2021/early 2022.

The SNB slowing (or stopping) CHF buying (and selling) of FX reserves would be a key catalyst to a CHF reversal.

Market Positioning and Expectations

As noted, interest rate markets are pricing about a 90% probability of a move from 1.75% to 2.0% in the SNB policy rate by the end of 2023 and a relatively stable policy rate in 2024 and 2025.

On the CHF, several key statistics stand out. 

First, positioning of traders that use short to medium time series momentum models (trend) screen extremely long the CHF. Statistical patterns show that a reversal in these positions usually provides forward-looking information as prices tend to follow such reversals.

Second, CHF currency future positioning from CFTC data indicates a relatively small short CHF position based off a metrics using a five-year z-score.

Third, currency volatility markets show very little tension as 25 delta EURCHF risk reversals are slightly negative and broader currency volatility has come down significantly over the course of 2023.  Currency volatility tends to be cyclical, and the current levels provide attractive entry levels, particularly if broader macro volatility will remain high as expected.

Trade Expression and Risks

There are several different convex trades with asymmetrical upside outcomes and controlled downside risk that can be constructed to express the view on Switzerland most directly.

Focusing on the currency markets, there are a few possibilities to express a view over varying time horizons, utilizing different products, and different currency pairs. 

1. Buying a EURCHF call option which provides defined downside risk and an asymmetrical payoff. 

In addition to the factors mentioned above, this trade leverages the price location of EURCHF at multi-decade lows and the seasonal tendency of EURCHF to move higher into year-end.

Example 1

Three-month EURCHF call, Strike price .9700, Delta 25, Premium cost 0.44% of Euro (spot .9593).

Target price of .9950 in spot provides a greater than 1:5 risk return ratio at expiration.

Example 2

Six-month EURCHF call, Strike price .9750, Delta 23, Premium cost 0.56% of Euro (spot .9593).

Target price of 1.00 in spot provides a greater than 1:4 risk return ratio at expiration.

2. Creating a currency basket of a short CHF currency position vs a diversified long currency basket 

The trade is more of a medium- to long-term investment expression that harvests risk premia of carry, value, and trend.  Risk is controlled by calibrating position size to a volatility target and/or specific stop loss level that allows for asymmetric payoffs through both carry and capital appreciation with defined downside risk.

In terms of carry, Japan is the only major economy that has lower interest rates than Switzerland.  The positive interest differential in the trade provides the opportunity to harvest significant carry premia.

From a value perspective, the CHF benefits from persistently low relative inflation over the longer term. However, the recent rise in the CHF REER will likely support a mean reversion down in the CHF over the short to medium term. 

Currencies tend to trend, and the CHF is no exception. A 30-day forward return regression model on EURCHF shows a strong tendency for trend continuation with a T stat of 10.0.  Over the past 20 days, the EURCHF has increased 11 days and decreased nine days. The past five days have seen an acceleration of this pattern. A continuation would support a broader and accelerated momentum shift downward for the CHF.

Example 1

Short the CHF vs an equal basket of US dollar, Canadian dollar, Brazilian real, and Polish zloty.

Carry on the basket is just under +6% annualized based off 3m market rates. In addition to carry, capital appreciation of the basket is expected to be greater than +5% driven by both the momentum factor and reversion to mean from the value factor. 

Encapsulated in the diversified geographic basket are several idiosyncratic elements that exploit return opportunities and reduce risks. US dollar exposure provides some protection from a ‘risk off’ environment that may benefit the CHF. The Canadian dollar has a positive correlation to energy prices and hedges some Swiss inflation risk to such.  Brazilian real exposure exploits high nominal and real rates and an undervalued currency.  Polish zloty exposure utilizes attractive price entry levels given the recent depreciation and the opportunity for asymmetric positive outcomes in front of the October parliamentary elections.

3. The 1-3-year sector of the Swiss yield curve is attractively priced as yields are likely to fall over the coming year.

4. Swiss exporters with strong pricing power, product diversification, and attractive price entry levels like Nestle will likely rise or outperform equites that are levered to consumption and credit cycles.

Conclusion

The 2020s are likely the beginning of a return to a higher frequency of both geopolitical uncertainty and macroeconomic policy variability among countries.

The feedback mechanisms of both these factors to markets will be one of continued and increased asset price volatility, as volatility tends to follow volatility and calm follows calm with a correlation of approximately 0.5.

Macro volatility statistically tends to persist. The 2010s were the anomaly, where the volatility of economic data and market prices were more than 50% lower than has been typical since 1970.

The evolution of Swiss monetary policy and the impact on the CHF is only one of many idiosyncratic opportunities in macro that can be used to create a diverse portfolio of both tactical and medium-term trades.

John Floyd is currently CIO of Floyd Capital, a macro trading and advisory firm. He was previously Head of Macro Strategies at Record Currency Management Inc., an $80bn currency manager.

Richard Jones writes about FX and rates markets for Macro Hive. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)