EUR/CHF: Welcome back, the Swiss franc

Firstly, he SNB retains its core view that the Swiss Franc is significantly over-valued. Undoubtedly the SNB would like EUR/CHF back above 1.20 and probably above 1.30 as well. One of the SNB’s primary tools for securing 1.20+ levels on EUR/CHF will be to remain consistently dovish in its message, well beyond when the ECB has tapered further (1H18) and raised interest rates (towards the end of 2018). Very low inflation provides good cover for the SNB to leave rates lower for much longer than the ECB, which will very much be the case for the whole of 2018 when Swiss headline CPI runs a full 1% below that of the Eurozone.

We do not expect the SNB to touch its targeted 3m Libor of -0.75% throughout 2018, meaning that interest rate differentials should support EUR/CHF:

• Initially at the longer end of the curve on the back of ECB QE tapering
• Then at the shorter end of the curve in the face of eventual ECB depo rate normalization in late 2018.

Monetary divergence between the ECB and the SNB should thus be a key driver of EUR/CHF strength over the next 18 months.

We agree with the SNB that the CHF is significantly over-valued. The scale of the potential medium-term EUR/CHF upside is corroborated by our medium term Behavioural Equilibrium Exchange Rate (BEER) model (which is a function of fundamental factors such as Terms of Trade, Productivity, and Government consumption). As the chart below shows, EUR/CHF remains heavily undervalued, by around 24% (which points at a medium term fair value of EUR/CHF 1.40). Hence, once EUR/CHF further regains properties of an ordinary cross (as well as its sensitivity to ordinary/normal drivers), the medium-term valuation factor should act as an accelerator of the persistent and ongoing EUR/CHF upside.

The de-leveraging of CHF loans gave the CHF a major boost after the financial crisis (think CEE mortgages). And the travails of the big banking groups CS and UBS prompted authorities to introduce Too-Big-To-Fail (TBTF) regulation, such that the tax payer should not be called upon in the event of a bail-out. Since then these banks have shrunk their balance sheets from 6.5 times to 2.5 times GDP and look largely there in terms of regulatory standards, so the Swiss banking system de-leveraging looks largely over

These big banks have been handed tough leverage ratios (core capital versus total assets) of 5%. As of Q217, CS had a fully loaded leverage ratio of 5.1%, while UBS was at 4.72%. We think broad-based deleveraging has largely played out now. For the CHF in particular, the chart below shows Swiss Banks’ foreign CHF claims (i.e. CHF deposits placed and loans granted abroad) having shrunk to CHF40bn from CHF125bn in summer 2008. That deleveraging, positive CHF trend looks over.

The second shoe to drop will be the CHF deposits placed with Swiss banks from abroad, which have risen to around CHF160bn from CHF80bn pre-crisis. How long will foreigners be prepared to hold those CHF, if the original factors that drove that portfolio allocation - particularly during the height of the Eurozone crisis 2011-12 – reverse? Timing that wholesale exodus from CHF deposits remains tricky, but moves towards a Euro 2.0 after the German elections in September or a successful passage of Italian elections in 1Q18 could prove a catalyst.