FX Weekly - Recovery of the Swiss franc

Interest rate spreads continue to drive EUR/USD

During the summer, financial markets focused mainly on developments in the US. Investors closely monitored domestic politics, the potential impact of the war on the midterm elections, the economy and the budget deficit. At that stage, higher US bond yields did not support the dollar because they mainly reflected the additional risk investors associated with holding US assets. However, since the Federal Reserve meeting on 16 September, higher yields have become an important source of support for the dollar.

In last week’s FX Weekly, we explained that interest rate spreads were putting pressure on the euro. Several spreads are important, especially those between the US and Germany. Expectations for both short- and long-term interest rates currently favour the US dollar over the euro. For example, EUR/USD has fallen in line with the two-year GE-US interest rate spread. The currency pair shows a similar relationship with ten-year nominal and real yield spreads. Overall, these developments continue to weaken the euro. The charts below show that both the two-year yield differential and the ten-year real yield differential have moved in favour of the US dollar.

Meanwhile, investors have shifted their attention from US politics and public finances to the eurozone. Large budget deficits are not only a US problem: the UK and France also face serious challenges. Several eurozone countries will also hold elections in the coming year. As a result, the growing gap between their government bond yields and German yields has become another factor weighing on the euro, as the charts below show.

Swiss franc behaviour is a good risk indicator

From June to October, the Swiss franc weakened against the euro. Low inflation made an interest rate increase by the Swiss National Bank unlikely. Meanwhile, the ECB had already raised its policy rate, and we expect two more increases in December and March. The Japanese yen has also become riskier as a funding currency for carry trades. As a result, investors increasingly prefer the Swiss franc and Swedish krona as alternatives.

However, when financial markets are concerned about political risks and public finances in the eurozone, the Swiss franc often strengthens against the euro because investors see it as a regional safe-haven currency. Switzerland also has a balanced budget. Recently, concerns about France’s public finances and election uncertainty in France and Spain have supported the franc. Investors are becoming less willing to use the franc to fund carry trades, and some may already have closed short positions in the franc. They prefer not to be short a currency that also has safe-haven qualities. The franc’s performance therefore gives a useful indication of what is currently driving financial markets.

Overall, we believe that financial markets are too optimistic about future Fed rate hikes and too pessimistic about developments in France. We therefore expect the euro to recover against both the US dollar and the Swiss franc. We maintain our year-end forecasts of 1.15 for EUR/USD and 0.95 for EUR/CHF.