The Swiss franc has seen a remarkable rally over the last few years, accelerating to hit nearly 9-year highs against the US dollar in recent months. As of Friday, the franc was up over 6.2% against the dollar year-to-date and 8% against the euro over the same period. This follows years of steady gains for the currency, which acts as a haven asset during market uncertainty and turmoil.
Key Catalysts Behind the Latest Franc Surge
Falling Global Bond Yields
Falling bond yields globally have been a major catalyst after the latest leg higher in the Swiss franc. As yields have tumbled in major government bond markets like the US and Eurozone, the relative yield advantage of holding Swiss debt has increased substantially.
For example, since early October, the spread between 10-year US Treasury yields and comparable Swiss yields has fallen by 60 basis points to just 3.17%. The yield differential between Eurozone benchmark German bunds and Switzerland has compressed even further – by 53 basis points over the same period to just 1.2%.
This growing yield advantage has made Swiss bonds appealing for global fixed-income investors versus European and US debt markets. Portfolio inflows into Swiss franc assets have accelerated markedly as a result.
Safe Haven Flows
It’s not just about differences in yields. All the uncertainty swirling around global markets has also pushed money into safer bets. Things like the Brexit drama, the US getting more protective on trade, and signs that world growth is slowing down have made markets jittery this past year.
As volatility has picked up, so too have speculative bets on further franc upside. CFTC positioning data indicates leveraged futures market participants have built substantial long positions.
Weaker Euro and Pound
Compounding gains against the US dollar, the Swiss franc has also benefitted substantially from specific Euro and British pound weakness.
The Euro has faced its headwinds from weakening Eurozone growth, inflation running below target and a need for expanded ECB stimulus. Meanwhile, Brexit chaos has weighed heavily on the pound.
With Switzerland standing as an island of relative stability versus its key European trading partners, the franc has reaped the rewards through a weaker EURCHF cross rate.
Concerns Around Swiss Franc Overvaluation
However, there are compelling reasons to question the sustainability of recent extreme Swiss Franc strength. The currency appears to be significantly overvalued at current levels against major peers by many valuation metrics.
For example, trade-weighted real effective exchange rate measures show the franc at decade highs in inflation-adjusted terms. This suggests the currency is anything but cheap for Switzerland’s major trading partners.
Likewise, purchasing power parity models indicate substantial overvaluation as well. If allowed to continue unchecked, this substantially damages Switzerland’s export competitiveness.
Yield Spreads Still Favor Foreign Assets
Additionally, despite market yield compression, Swiss government debt still fails to offer significantly higher relative yields than foreign equivalents. The yield spread of 3.2 percentage points favouring 10-year US Treasuries over Swiss bonds remains well above past turning points for the franc.
Historically, peak franc strength has reversed course near ~3.35% yield premiums for the dollar. That suggests further yield compression will be required to justify additional franc upside.
Currency Intervention Risks
Unlike major central banks abroad, the Swiss National Bank remains uneasy with continued gains in the franc, depressing import prices and domestic inflation. This raises the risks of direct intervention to counter the currency’s ascent through purchases of foreign assets.
While their December policy meeting took a conservative stance, the SNB has frequently shown a willingness historically to intervene to weaken excessive franc strength. This threat shouldn’t be ignored, with currency markets focused heavily on interest rate differentials.
Economic Risks Growing
Domestically, the impact of the strong franc is also increasingly worrying for the Swiss economy. Despite years of attempts to halt currency appreciation, consumer inflation has rolled back quickly to just 1.4% annually – well short of the SNB’s near 2% objective.
With global growth showing further weakness, additional franc strength risks increasing challenges to achieving the SNB’s inflation mandate over the medium term.
Key Takeaways – Challenges Ahead Despite Historic Gains
While the multi-year uptrend for the Swiss franc has been undoubtedly impressive, the currency faces intensifying headwinds following its push to fresh 9-year highs. Extreme overvaluation, the threat of direct intervention, and increasing challenges for Swiss inflation all cast doubt on additional sustained upside.
For global investors, current historically wide yield spreads continue to argue for maintaining foreign asset exposure versus piling into overpriced Swiss debt. Within Switzerland, officials are likely to grow increasingly concerned by the economic risks of further enduring franc strength.
In FX markets, traders should be cautious before chasing upside targets for the franc beyond current levels. While remaining a haven asset, countervailing forces appear to be building that challenge the narrative of unchecked strength. Risk-reward is becoming increasingly skewed to the downside after this year’s speculative-driven surge.