The Swiss Franc Factor

By Svetoslav Georgiev - Chief Market Analyst - Hantec Markets

Over the past two years not many currencies have attracted investors’ attention. The Swiss Franc is one stark exception to this rule. The Swiss Franc has traditionally been attractive in times of uncertainty and inflationary fears, as some may still remember the 1970s, when the Swiss government had to use a range of measures, including negative interest rates, to prevent foreigners from maintaining deposits in Swiss Francs. The Franc’s perceived stability has pulled capital flows during recent market turbulence along with other safe assets such as Gold and, to a lesser extent, government bonds.

The Franc is special to investors not only because of the stable macroeconomic indicators of the Swiss economy, with an inflation rate below 1%, healthy growth of around 2%, and consistent trade surplus, but also because of its long established appeal as a safe asset. Recently, slow recovery of equity markets and sovereign debt crises have intensified investors’ quest for alternatives. In this environment the Swiss Franc has emerged as a favourite choice for anyone looking to lay low until the storm has passed.

Massive flow of capital to the Swiss currency has also created a number of problems. The Swiss National Bank (SNB) calls the currency “massively overvalued” and is concerned about the effect on economic growth and exports. Many companies suffer from converting earnings into Swiss Francs, where even after profiting from operations in other countries end up with a loss in Swiss Francs. Nevertheless, the Franc now stands together with Gold as a preferred asset for risk averting investors.

Safe haven assets are associated with low risk and abundant liquidity, assets investors turn to during periods of economic uncertainty. From this perspective a safe haven asset acts as a hedge to conventional instruments such as stocks (Kaul and Sapp, 2006) or at least does not track their movement in time of uncertainty.

To explore the safe haven effect of the Swiss Franc we can relate the value of the currency to the price of Gold and to the benchmark equity index Dow Jones Industrial Average (DJIA) over time. The historical data covers a period of approximately 2 years, characterized by unsteady economic recovery, profound uncertainty in the economic environment, and continued growth of precious metals as alternative safe investment. Furthermore, in order to identify short term risk aversion effect, the most recent period of stock market stress after the US sovereign credit rating downgrade by Standard & Poor’s is considered. While risk aversion effects are often displayed within short time spans in reaction to a particular high-stress economic event, it is also important to look for a long term shift to holding the Swiss Franc as a safe asset. Market volatility has been considered in the past as a determinant of a short term risk aversion effect for the Swiss Franc and clear evidence has been provided that immediately after a high-stress event the currency appreciates (Soderlind, 2008). A reference to flight to quality as an effect in times of economic uncertainty is also due. Market crashes spill over international borders and investors respond with reservation, conservatism, and demand for safety. These motives are especially relevant in times of near zero interest rates in the developed world, when a traditional driver of currency trading-the interest rate differential is nearly eliminated. Thus, any visible shift in demand for a currency will be a display of demand for safety.

The first graph of the US Dollar to Swiss Franc exchange rate, on an inverted scale, and Gold clearly shows the co-movement of the currency and the precious metal over the past years. It is especially noticeable in the second and third quarter of 2011, when the sovereign debt crises in Europe surfaced and the concerns about the US economic recovery made the possibility of a double-dip recession tangible. A statistical time series model revealed a highly significant direct relationship between the value of the Swiss Franc and the price of Gold. For the specified period for every $100 of increase in Gold price the Swiss Franc gained 2.69 centimes. At the same time, the value of the Franc climbed consistently with the DJIA index over the two year period. Despite being unexpected, this result reflects deep concerns permeating markets in the aftermath of the 2008 financial crisis, a period when safe haven appeal remained active together with gradual shift of investments to traditional asset classes. Asset prices grew fuelled by expansionary monetary policies, especially the Quantitative Easing programs of the Federal Reserve. In this environment, the value of the Swiss Franc was explained in over 70% of the days within the period, by the values of Gold and the DJIA.

When the data is considered (second graph) at a more granular level, for the months of July and August 2011, an inverse relationship between the value of the Swiss Franc and DJIA is clearly identifiable. More importantly, within the short-term sample the change in value of the Franc could be explained in 87% of the cases based on the price of Gold and the level of DJIA. In confirmation of previous results, risk aversion motives drove the peaks in demand for the Swiss Franc and pushed its rate to a record at 0.72 centimes for one US Dollar. Once again, investors afraid of holding traditional risky assets turn to the refuge of the Swiss currency. High market volatility is the signal that triggers this capital flight to quality.

Unquestionably, an expensive Franc is a headache for the SNB, posing a threat to economic growth and pressuring exports. Nevertheless, at times of short term economic stress and during prolonged periods of uncertainty, the Swiss Franc attracts investors as a safe store of value, which protects assets from extreme market volatility and inflationary pressure. The immediate risk aversion effect appears at times of economic stress, observed at a more granular level over a short period of time. This effect was visible during the recent weeks of extreme market volatility in the aftermath of the US downgrade and European sovereign debt crisis contagion fears, taking the Swiss Franc to all time high against the US Dollar. The Franc acted as a perfect hedge to equity markets collapse.

On the other hand, when the Swiss Franc is benchmarked against Gold during the last two years, its safe haven effect also appears. This long term shift of investors’ preferences to holding the Swiss currency is a signal of deep concerns about the global economic recovery and diminishing investment alternatives perceived as safe. The rise of Gold and the Swiss Franc to a position of central assets in investors’ portfolios is a reminder of the long road to global economic recovery still ahead.