Market Analysis

Image Credit: Reuters

As investors increasingly turn to the Swiss franc as an alternative to Japan's yen for funding carry trades, the risk of the currency experiencing one of its notorious rapid rallies remains a concern.

The Swiss franc has long been a staple in the popular carry trade strategy, where traders borrow low-interest-rate currencies to invest in higher-yielding assets. Its appeal has recently grown as the yen’s attractiveness has diminished. In August, yen carry trades collapsed following a strong rally in the currency, triggered by weak U.S. economic data and a surprise rate hike by the Bank of Japan, which contributed to global market volatility.

The Swiss National Bank (SNB) was the first major central bank to initiate an easing cycle earlier this year, setting its key interest rate at 1.25%. This allows investors to borrow francs at low costs to invest in other markets. In contrast, interest rates are much higher in other regions, ranging from 5.25% to 5.50% in the United States, 5% in Britain, and 3.75% in the eurozone.

"The Swiss franc is once again a favored funding currency," said Benjamin Dubois, global head of overlay management at Edmond de Rothschild Asset Management Suisse.

Stability

The franc is currently near its highest levels in eight months against the dollar and in nine years against the euro, underscoring its status as a safe-haven currency and reflecting expectations of rate cuts in Europe and the United States. However, investors are banking on a gradual decline in the franc's value, which could enhance returns on carry trades.

Speculators have maintained a $3.8 billion short position against the Swiss franc, even as they have swiftly shifted to a $2 billion long position on the yen, according to data from the U.S. Commodity Futures Trading Commission. A large short position is typically viewed as an indication that a currency is being used to fund carry trades.

"There is now more two-way risk in the yen than we've seen in quite some time," noted Kamal Sharma, senior G10 FX strategist at Bank of America. "The Swiss franc appears to be the more logical choice as a funding currency."

Bank of America recommends buying sterling against the franc, suggesting that the pound could rally due to the significant interest rate gap between Switzerland and Britain—a sentiment echoed by Goldman Sachs.

The SNB is expected to cut rates further in the coming months as inflation declines, which would reduce franc borrowing costs and potentially weigh down the currency, making it cheaper for borrowers to repay loans.

Central bankers are also cautious about allowing the franc to strengthen further, given the challenges it could pose for exporters. Bank of America and Goldman Sachs speculate that the SNB intervened to weaken the currency in August.

"The SNB is likely to guard against currency appreciation through intervention or rate cuts as needed," said Michael Cahill, G10 currency strategist at Goldman Sachs.

Inherent Risk

However, the Swiss franc, often referred to as the "Swissie" in currency markets, can be unpredictable. Investors tend to flock to the currency in times of market anxiety due to its long-standing safe-haven status.

Cahill advised that the franc is best used as a funding currency during periods of investor optimism. A sudden rally in the currency used to fund carry trades can quickly erase gains and force investors to unwind their positions, as demonstrated by the yen’s recent volatility. High levels of market volatility or a decline in the higher-yielding currency can have a similar effect.

When asked by Reuters, the SNB and Swiss regulator Finma declined to comment on the impact of carry trades on the Swiss currency.

As stock markets plummeted in early August, the Swiss franc surged by as much as 3.5% over two days. The franc-dollar pair has shown sensitivity to the U.S. economy, often rallying sharply on weak data that lowers U.S. Treasury yields.

"Carry trades are inherently risky, especially those funded with safe-haven currencies," said Michael Puempel, FX strategist at Deutsche Bank. "The main risk is that in a risk-off environment, when yields decline, yield differentials compress, causing the Swiss franc to rally."

A gauge of investor expectations for Swiss franc volatility, derived from options prices, is currently at its highest level since March 2023.

"Given the actions of central banks, it’s understandable why some carry traders might prefer the franc over the yen," said Nathan Vurgest, head of trading at Record Currency Management. "The ultimate success of this carry trade may still depend on how swiftly it can be closed in a risk-off scenario," Vurgest added, referring to moments when investors retreat from riskier trades to safeguard their capital.

Paraphrasing text from "Reuters" all rights reserved by the original author.