While investors turn to the Swiss franc as an alternative to the yen to fund carry trades, the risk of a quick rebound in the currency always exists.

The Swiss franc has long been used in this popular strategy, in which traders borrow in a currency with a low interest rate and then exchange it for other currencies to buy higher-yielding assets.

The appeal of using the Swiss franc for carry trades has grown further as the yen’s appeal has waned. In August, the yen rebounded sharply, roiling global markets, as the yen’s carry trade collapsed amid weak U.S. economic data and a surprise rate hike by the Bank of Japan.

The Swiss National Bank (SNB) was the first major central bank to start an easing cycle earlier this year, with its key rate at 1.25%, allowing investors to borrow Swiss francs cheaply to invest elsewhere.

By comparison, rates in the U.S. are in the 5.25%-5.50% range, in the U.K. they are 5% and in the eurozone they are 3.75%.

“The franc is back as a funding currency,” said Benjamin Dubois, head of global coverage management at Edmond de Rothschild Asset Management Switzerland.

stability

The Swiss franc is at its strongest in eight months against the dollar and nine years against the euro, reflecting its status as a safe-haven currency and expectations of rate cuts in Europe and the U.S. But investors hope the currency's value can gradually fall, which would boost returns on carry trades.

Data from the U.S. Commodity Futures Trading Commission (CFTC) showed that while speculators suddenly shifted to a $2 billion long position against the yen, they still held $3.8 billion in short positions against the Swiss franc.

Analysts generally view the large number of short positions as a sign that the currency is being used to fund carry trades.

“There is more risk in both directions for the yen now than before,” said Kamal Sharma, G10 FX strategist at Bank of America. “The Swiss franc seems to be a more reasonable funding currency choice.”

Bank of America recommended that investors buy GBP/CHF, arguing that the wide interest rate gap between Switzerland and the UK could lead to a rise in the pound, a view echoed by Goldman Sachs.

The Swiss National Bank looks set to cut interest rates further in the coming months as inflation weakens. That would make it cheaper to borrow in Swiss francs and could weigh on the currency, making it easier to repay for those who have already borrowed in francs.

The Swiss National Bank also seems reluctant to see the currency strengthen further, partly because it would cause pain to exporters. Bank of America and Goldman Sachs said they believe the Swiss National Bank had already taken action in August to weaken the currency. Michael Cahill, Goldman Sachs' G10 currency strategist, said:

“The SNB could intervene or cut rates to prevent the currency from appreciating.”

'Inherent risks'

However, the Swiss franc can be an unreliable friend.

Because of the Swiss franc’s long reputation as a safe-haven currency, investors tend to flock to it when they feel nervous. Cahill said the Swiss franc is best used as a funding currency during moments of investor optimism.

A quick rebound in a currency used to fund a carry trade can quickly wipe out investors’ gains and cause them to quickly unwind their positions, as the dramatic performance of the yen showed. A decline in a highly volatile or high-yielding currency can have the same effect.

The SNB and Swiss Financial Market Supervisory Authority (FINMA) declined to comment on the impact of carry trades on the franc.

In early August, the Swiss franc rose 3.5% in two days as stocks tumbled. The Swiss franc is very sensitive to the U.S. economy and typically rises sharply on weak U.S. economic data, which causes Treasury yields to fall.

“Any carry trade is inherently risky, particularly for those financed using safe-haven currencies,” said Michael Puempel, a currency strategist at Deutsche Bank.

“The main risk is that when yields fall in a risk-off environment, spreads compress and the Swiss franc could rebound,” Puempel added.

A measure of investor expectations for Swiss franc volatility, derived from option prices, is now at its highest level since March 2023. Nathan Vurgest, head of trading at Record Currency Management, said:

“Given the central bank, you can see that some carry players may prefer the Swiss franc over the yen. Whether this carry trade will ultimately succeed may still depend on how quickly traders can unwind their positions amid risk aversion.”

The article is forwarded from: Jinshi Data