Hedge funds test Swiss tolerance with franc gambit

The Swiss currency on Thursday climbed to a 4-1/2 year high of 1.061 francs per euro, fast approaching the point where its central bank will feel compelled to ensure currency strength does not harm the country's export-dependent economy, these investors argue.

A catalyst was Switzerland's inclusion last month into a US Treasury watchlist for currency manipulation, which led many to bet the central bank would take a more hands-off approach to the franc.

Concerns about the euro zone economy have also contributed significantly to franc gains versus the euro, handing a 2%-plus profit to hedge funds that piled into the franc and sold the euro a month back.

But many reckon the SNB remains too concerned about franc strength pressuring inflation and exports to stop intervening altogether.

"We think the move downward (in the euro/franc exchange rate) has been overdone," said Van Luu, Head of Currency and Fixed Income Strategy at Russell Investments.

Luu said the Swiss National Bank would "continue to manage the FX as it has explicitly stated its role in monetary policymaking," adding that the franc was the most shorted currency in its $5.6 billion FX fund.

According to some measures the franc is now at least 4% overvalued. Yet speculators' net long position on the franc versus the dollar has swelled to the biggest since late-2016. 

These positions are at risk of a shakeout if the central bank intervenes suddenly. 

Against the euro, hedge funds have focused on buying the franc and selling the euro on spot markets, often magnifying their bets with leverage. Option traders said volatility on euro/franc derivatives markets was low and trading volumes very thin.

What would it take to force the SNB's hand?

Ian Gunner, portfolio manager at hedge fund Altana Wealth, said headlines about franc strength was "the last thing the SNB wants to see.

"I'm looking for a sign that we have bottomed against the euro," he said, pointing to 1.05 francs as the level beyond which the SNB would have to act.

Investors interviewed for this article generally saw 1.05 francs per euro - just 1% from current levels - as the threshold.

Andreas Koenig, global head of FX at Amundi Asset Management, said the threshold had shifted from a range of 1.10-1.08 francs per euro before the watchlist was released to 1.08-1.06 francs today, a band it is close to breaching. 

NOT SO STRONG

Still, the SNB may not be panicking just yet.

Despite the franc's gains versus the euro and outperformance compared to another safe-haven currency, the yen versus the dollar, its showing more broadly is less impressive even with safe-haven flows driven by China's coronavirus outbreak.

The franc is down 1% versus the dollar so far in 2020.

And while the trade-weighed franc index  has climbed, it is well off 2017 highs when the SNB called the currency 'significantly overvalued'. 

The SNB denies its interventions aim to give Switzerland a trading advantage, instead noting the impact a highly-valued franc has on inflation.

But the symbolism of appearing on the watchlist may have taken on new meaning under US President Donald Trump.

"It's a new environment. These are not empty threats. They (the US) will follow through," said Stephen Jen, hedge fund manager at Eurizon SLJ Capital, describing the political capacity of Switzerland to intervene as "compromised".

Recent sight deposit data, a gauge of Swiss central bank activity, indeed suggests the SNB has not been intervening significantly.

The bank is - at least verbally - sticking to its guns. Chairman Thomas Jordan said last week the SNB would still intervene if necessary.

Amundi's Koenig is positioning for "tactical recovery" in euro/franc.

"The market thinks the SNB cannot do anything anymore. But the SNB is not at the end of its possibilities."