Swiss Franc to Outperform other 'Safe' Currencies

A comeback of concerns about global economic slowdown has induced strong demand for safe-haven assets. While stocks, commodities and other growth assets got dumped, bond prices rallied, pushing yields to record lows, which currencies that are considered as 'safe' soared. While USD, JPY and CHF are traditionally considered shelters when risk aversion increases given the abundant liquidity and solid economic backdrop in the countries, we expect strength of Swiss franc to continue in the near-term as market confidence remains fragile. It should also outperform USD and JPY as Switzerland has relatively stable fundamentals than the US and Japan.

Swiss Franc resumed rally against the dollar and the euro in early August amid increased uncertainty in US economic growth and reemergence in sovereign crisis risks in peripheral European economies. Over the past 2 weeks, USDCHF dropped -0.45% while EURCHF plunged -4.81%. Yet, positioning is neutral for the franc, with all long positions squared last week, in the short-term, suggesting possibility for further upside. Indeed, we believe CHF will benefit more than other currencies in the recent turmoil.

Economic data in Switzerland shows that recovery is underway. The latest manufacturing PMI report rose to 66.9, the highest reading on record, while the KOF leading indicator stayed at elevated level despite a mild pullback to 2.23 in July. It's widely expected that the GDP should mark a 4th consecutive quarterly growth in 2Q10. Interest rates remain at record low levels with the 3-month LIBOR target staying a 0.25%. As economic growth gathers momentum, the SNB may consider raising the policy rates. While consensus forecasts the first rate hike to take place in 2011, some market participants bet it will begin in 2H10.

Economic development in Japan and the US are obviously worse. With deflationary worries lingering, there have been rigorous talks about government intervention of JPY's rally and additional easing measures from the BOJ to stimulate growth. Though neither the Ministry of Finance nor the Bank of Japan has announced anything concrete, there have been speculations regarding the issue from time to time. In our opinion, the bottom-line is that the long-term USDJPY of support of 79.75 should remain intact.

Disappointing US economic data has exacerbated concerns over economic slowdown. Moreover, the Fed's re-entry to QE suggests the policy rate should stay at exceptionally low levels for an extended period of time. A low interest rate environment should weigh on USD. Meanwhile, the size of the massive US fiscal deficit will hurt the currency. Moody's Investors Service said the top AAA ratings of the US, UK, France and Germany are well positioned but face new challenges that increase the possibility of a downgrade. In the US, 'a strategy for debt stabilization is still in the early stages of being developed'. We believe this is the long-term overhang of the country's economy and the dollar.

The major risk to the growth outlook and SNB's tolerance toward appreciation in CHF is inflation. Headline CPI has been contracting over the 3 months. In July, CPI declined -0.8% from a month ago and eased to +0.4% on annual basis. Recent appreciation in Swiss franc has increased risks that core inflation will turn negative this year. The SNB will be cautiously monitoring the August report and may act accordingly, i.e. to intervene against CHF appreciation, should the situation deteriorate.