The EUR/CHF currency pair, which expresses the value of the euro in terms of the Swiss franc, has been trading higher in recent weeks. While euro sentiment is thought to have improved, the so-called positive sentiment has not pervaded all EUR FX crosses, as I demonstrated in the latter part of a recent article (covering EUR/NZD). The euro has improved mostly with respect to the U.S. dollar, as USD has weakened considerably across the board.
However, EUR/CHF may prove to be an exception. While EUR is struggling to gain ground against other major currencies, recent Swiss franc weakness has enabled EUR/CHF to steady itself and begin to approach its 2020 highs above the 1.09 handle. The pair began 2020 by trading just under this level, while EUR was able to exceed this level only briefly in June (as shown in the daily candlestick chart below).
(Chart created by the author using TradingView. The same applies to all subsequent candlestick charts presented hereafter.)
In early July, before the most recent rise, I did believe that the outlook looked constructive for EUR/CHF. My view was based on the fact that since the interest rate spread was effectively zero (and it is unchanged since then), relative political risk was at the forefront of this pair’s valuation. Given continued SNB intervention to help soften any CHF strength, and positive risk sentiment, there was a chance that EUR/CHF would rise. This was especially true considering the potential for increased harmony across the European Union with jointly-issued debt (per the proposed EU Recovery Fund).
I did admittedly suggest that further downside was probable, but only on the basis of the trend, which seems to have promptly reversed. Yet EUR/CHF still has not taken out its 2020 highs, so a degree of indecision still seems to be present. One interesting article from Bloomberg recently made the following important point:
Investors may have thought that the gigantic stimulus package agreed by EU leaders in July is a done deal. It’s not. The plan for 750 billion euros in joint debt issuance still needs unanimous approval from the bloc’s parliaments, with Hungary threatening to hold back ratification until it’s reassured the disbursements it’ll receive won’t be subject to strict rule-of-law standards. The stimulus package also needs approval by a fragmented EU Parliament, which has threatened to block it.
While the joint debt issuance is constructive for both reduced European Union break-up risk (i.e., due to greater implicit integration) and also higher European yields (Germany has for a long time been averse to spending, and so some have seen Germany’s approval of this prospective recovery fund idea as potentially positive for EUR yields), it is not a done deal. Perhaps markets have got ahead of themselves, and perhaps further progress is needed before we see a sustained EUR advance against USD and CHF.
Both USD and CHF are safe havens. USD is viewed as a safe haven for several reasons. The U.S. has historically outperformed other countries economically, and the U.S. maintains the petrodollar system (most oil trade is conducted in U.S. dollars), and furthermore the U.S. equity market has been the most popular among international investors for a long time (outperforming other major international equity indexes). For many reasons, USD still remains in high demand especially among central banks, whose FX reserves are approximately 60% USD claims (and only 20% EUR).
Meanwhile, CHF is also a safe haven, owing to the relative political stability of the small country (most relevantly with respect to European Union) and its historically positive current account surpluses (which provide the country’s currency with a natural degree of support). In spite of the country’s deeply short-term rate of -0.75%, CHF remains in high demand for these reasons, and the country maintains a high standard of living where residents enjoy a higher average nominal GDP per capita than almost all other countries in the world.
Because of these differing but still not categorically dissimilar characteristics, both USD and CHF tend to correlate positively versus other currencies, which also enables USD/CHF to often trade without too much volatility.
With EUR/USD advancing, this might therefore lend further support to EUR/CHF appreciation, and most recently it has. However, the recent support has been limited. With the United Kingdom’s trade deal deadline still in sight at year-end, and with the potential for either another wave of COVID-19 infections across Europe and/or a break-down in progress regarding the EU Recovery Fund project, EUR risks still remain.
If we think about relative political risks, CHF always seems to have an advantage, considering the stability of Switzerland in light of the rest of the world. Perhaps this is why CHF remains in high demand, and this really goes to show the power of political risk in the FX space; as I have written before, confidence is the most important factor. Using OECD data, I construct the Purchasing Power Parity model below that shows that EUR/CHF actually remains at a deep discount in light of EUR’s relative purchasing power.
In the chart above, the red line represents the rolling PPP fair value estimate (most recently as of 2019), while the black line represents EUR/CHF price action on a weekly closing basis. The upper band (which is not visible) and the lower band represent levels that are 40% above and below (respectively) the PPP model’s fair value estimate. Notice that during the period from 2000 to present, EUR/CHF has remained at a steep discount, not even coming into contact with the PPP value once (the upper band is not even visible on the chart, as it is simply too far away to be relevant to us). The variance to PPP has been consistently negative, only to differing degrees over time.
EUR/CHF almost made its way to 1.70 in 2007/08, yet the Great Recession sent the pair substantially lower just as the PPP fair value estimate fell over this period. When the SNB broke its EUR/CHF peg in January 2015, EUR/CHF dropped to a level that essentially represented a 40% discount to the PPP value. The chart below illustrates the variance (i.e., discount) historically to the running PPP value through to the end of 2019. The chart below uses the same data as the chart above.
EUR/CHF is trading at a historically deep discount, even relative to its previously pessimistic history. It is worth noting that due to the higher GDP per capita in Switzerland, the GDP-adjusted discount is potentially far lower. For instance, The Economist’s Big Mac Index indicates that CHF is overvalued by 44% on a non-adjusted basis (July 2020), but overvalued by only 2% on an GDP-adjusted basis. Still, exports remain important to the Swiss economy, and the SNB makes repeated attempts to intervene to stem any CHF/EUR strength.
Over the medium term, because of several risks that remain on the horizon, general uncertainty is likely to moderate any positive EUR/CHF sentiment and investor confidence. However, there is clearly plenty of potential for EUR/CHF to trade higher. The PPP value between EUR (in this case the euro area) and CHF (representing Switzerland) has been fundamentally steady over the past few years (averaging at around 1.64 since the start of 2015). The current price of EUR/CHF is just over the 1.08 handle.
Since the difference (regarding PPP) is likely far lower on a GDP-adjusted basis, it is unlikely that EUR/CHF would be able to stage a sharp recovery to the upside (unless the Swiss economy deteriorated significantly relative to the euro area). However, an upside bias should be considered at this juncture, considering the stability of the PPP value and the potential for longer-term euro area integration. This pair simply needs to see itself through 2020, one of the most uncertain years in global markets for many years, before light will begin to emerge at the end of the tunnel.
If 2020 is not enough to shake EUR/CHF significantly lower, I believe this pair will begin to establish a floor of sorts, and CHF may finally be able to concede some strength to EUR. Rates between these nations are likely to remain close, probably unchanged, and in negative territory for the time being. Meanwhile, Swiss inflation has been in deflation (negative) territory year over year throughout much of 2020, which certainly provides another headwind for EUR/CHF (deflation, as opposed to inflation, usually leads to a stronger currency; lower inflation technically improves inflation-adjusted “real yields”).
(Source: Trading Economics)
Once again, no significant surge upward in EUR/CHF can be expected. But a gradual improvement should probably be our bias over the longer term into 2021. Confidence tends to reign supreme, and I think the broader backdrop is constructive for EUR/CHF, but near-term risks warrant some hesitation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.