Analysis-Investors set sights on Swiss franc for popular carry trades after yen intervention

In a surprising turn of events, recent U.S.-Japanese intervention in support of the yen could lead to a weaker Swiss franc, providing relief to Swiss companies and policymakers who have long struggled with their currency's strength. The franc has been 12% stronger against the euro than it was five years ago, thanks to Switzerland's persistent current account surplus, solid public finances, low inflation, and safe-haven inflows. This strength has made Swiss exports more expensive, hindering economic growth.

The yen and the franc both fall within the FX carry trade, weakening when investors borrow in these currencies with low interest rates to sell them and purchase assets yielding more elsewhere. Currently, the yen is the funding currency of choice, but traders are wary of further intervention risk. This has sparked a rotation towards the Swiss franc, which analysts and investors believe could continue if Washington and Tokyo successfully engineer a stronger Japanese currency.

Market participants are considering rotating some of their funding positions, according to Fredrik Repton, a senior portfolio manager at Neuberger Berman. The euro/Swiss franc pair is near its weakest in around a year, having softened about 4% from March's 11-year peak near 0.9, and is down nearly 7% from an 11-year high hit versus the dollar in January. Rabobank recently revised its 9- to 12-month target for euro/Swiss franc to 0.95 from 0.94, reflecting expectations of further franc weakness.

Carry trades have been performing exceptionally well in recent years, fueled by low FX volatility. However, they become more precarious when a currency starts to fluctuate, eroding the modest profit from rate differentials. Analysts find it difficult to quantify the size of the carry trade, but currency short positions, or bets on an asset weakening, serve as a good proxy. The recent intervention has prompted the unwinding of yen short positions, bringing the outstanding number closer to that of the franc.

While the yen is expected to remain a popular carry trade choice, intervention risk is making some investors reconsider betting against it. Japanese rate-hike expectations and speculation that Japan's Government Pension Investment Fund may shift allocations towards domestic investments are also influencing yen dynamics. With borrowing costs set by the Swiss National Bank, the franc appears to be a more attractive carry trade alternative to the Japanese currency, as Swiss rates are lower, and the franc's volatility is lower.

Swiss rates are currently at 0%, while Japanese rates stand at 1%. BofA, a global bank, has recommended selling the Swiss franc against the yen, targeting 190 yen per franc, from the current level of 196 yen and 200 yen before the recent intervention. The recommendation is partly due to stabilizing Japanese balance of payments but is also supported by the fact that funding in Swiss francs is more attractive than in yen.

A weakening of the franc as a result of a shift to using it for carry trades would be welcomed by the SNB, which has promised to intervene if necessary to weaken the currency. Neuberger's Repton is less negative on the Swiss currency than he was two months ago, given recent sharp moves, but still dislikes it. ING's Turner believes a shift to using the franc as a funding currency instead of the yen is still in the early stages but could become more prevalent.