A big part of Swiss consumption is imported from Germany. Therefore Swiss inflation is often correlated to German inflation. Capital flows often move to Switzerland and Germany at the same time.
Correlations between CHF and the German economy
The relationship between CHF and the German economy is very close for the following reasons:
- A big part of Swiss consumption is imported from Germany. Therefore, Swiss inflation is often related to German inflation.
- Germany is by far the biggest Swiss trading partner. Higher German spending is positive for the Swiss economy.
- Capital flows often move to Switzerland and Germany at the same time. The most prominent example is the housing market. Both Germany and Switzerland had a weak housing market between 1994 and 2006 and a strengthening one after the financial crisis.
- Both are inflation-hedges: While the German Mark improved by 30% against the dollar in the early 1970s during the Great Inflation, the Swiss franc rose by 40%.
- Quantitative trading algorithms have incorporated this strong relationship (and some how economic history!!). After good German fundamental data the EUR/CHF often weakens. We explain these price movements in the our daily news column on gold and CHF.
Apart from the relation to Germany, there are particular reasons why the Swiss outperforms the euro:
- The Swiss-European bilateral agreements in 2004 showed a new pattern of immigration to Switzerland: Highly qualified. Many highly-qualified Germans, e.g. computer scientists and engineers, moved to Switzerland, to a country with the same language and a closely related culture.
- Until the 1990s, Switzerland had enough capital but was missing labour, especially in the low-paid sectors. During the IT boom in the 1990s it became obvious that Swiss companies were also missing highly qualified personnel. With the bilateral agreements and with the financial crisis, they managed to overcome this lack with many talents from Europe, but also some from the United States. One example was 2008/2009, when the American Catarpillar laid off many engineers in the U.S. and elsewhere, but the Swiss ABB hired many of them.
- While many people think that Germany is the “best organized” economy in the euro zone, Switzerland is even better organized than Germany. One may think that comparing Germany to Switzerland is like comparing Italy to Germany.
New highs in EUR/USD result in new lows of USD/CHF
The immediate result is the following technical rule, that has been valid since early 2008 – effectively since the German economy clearly outpaced France, Southern Europe and – as for GDP per capita growth – the United States.
Here is the chart for EUR/USD and the CHF/USD (inverted) between 2011 and 2013 (click to expand):
This rule implies that only if the United States recovers then EUR/CHF can finally rise.
An example of the CHF-Germany correlation in macro algorithm
The following economic data as January 23, 2014 show the strong relationship between the Swiss franc and the German economy, but also of Norway and Sweden. For us this correlation is implemented in macro arbitrage algorithms by major investment banks.
CHF appreciates against EUR, when German data is clearly better than European data, as shown above. In the current low inflation environment, EUR/CHF is (slightly) negatively correlated to stocks performance. In this case, however, the stock market data would have explained only a EUR/CHF depreciation of around 5 bps, and not 30 bps. Both NOK and SEK appreciate against EUR, too, when German data is better. The current global disinflation period, is however, relatively bad for NOK that usually profits on higher rates.
The relationship between CHF and gold
Many people think that Switzerland is related to gold due to its inflation-hedging safe-haven status. Historically this is true. With rising U.S. inflation in the 1970s gold appreciated to record-highs. So did the German Mark and even more the Swiss franc, that maintained low inflation levels.
However the strong gold-CHF relationship broke from 1985 to 2007.
Between 1985 and 2001: the reasons were the relative weakness of gold and the good performance of the U.S. economy, topping in the dot com bubble.
From 2001 to 2007, the carry trade strengthened gold and the related Emerging Markets. but weakened the franc and related Germany. Switzerland had to digest the bust of the property bubble of the 1990s. Both Germany and Switzerland decided not to follow the spending rush of the U.S., the UK and Southern Europe.
In 2010 and 2011 the relationship between gold and CHF became parabolic. Gold tumbled only three weeks after the SNB introduced the cap.
Due to the weakness of Emerging Markets since 2012, CHF could far outperform gold. That resulted in SNB losses of 13 bln. francs only on gold holdings in Q2/2013.
The German economy, China, gold and CHF
Inflation is no longer the principal concern for the American economy and investors: this is the slow growth in both employment and GDP. However, similar to the 1970s, gold, German stocks and the Swiss franc are seen as alternatives.
German and Swiss engineering and machinery firms have a strong exposure to Emerging Markets and in particular to China. While Germans concentrate more on machinery and engineering, the Ricardian comparative advantage for Switzerland is the luxury sales to rich clients from Emerging Markets, e.g. watches, precision instruments, jewellery, luxury tourism and pharmaceuticals. We all know that gold rises with higher oil prices, so does the Swiss franc. The reasons are:
- Oil and gold prices rise with higher GDP growth and demand, especially from Emerging Markets and their central banks. In risk-on periods the latter often want to reduce their US dollar dependency.
- Higher prices for imported oil increases the U.S. trade deficits and weakens the greenback.
- Gold production costs and consequently gold prices rise when oil inches up.
- For the Swiss, higher oil prices are neutralized thanks to small distances and higher sales to their rich Middle Eastern clients. Effectively Switzerland has a trade surplus with the Middle East while the U.S. has a big deficit.
- Since the Swiss concentrate on the luxury sector, prices and exchange rates are not big issues, but a slowing demand from Emerging Markets or from the biggest trading partner, Germany, is.
The huge Swiss trade surplus with the United States in the pharmaceutical sector may additionally strengthen the Swiss economy, keyword “Obamacare”. On the other side, Switzerland is less concentrated on China than German exporters are. This is visible in the latest Swiss Manufacturing PMI: with 57.4 it was far higher than the German one of around 51, which was partially due to Chinese weakness. The fact that Swiss exporters are oriented more towards America than Germans, is ignored by quant algos. Effectively, during the German and Chinese weakness in April/May 2013, EUR and even more the USD started to appreciate against CHF. Interestingly, the German and European recovery since July stopped the dollar strength but also the one of EUR/CHF. See more.
On the other side, the CHF correlation with Germany and China was overemphasized in particular in August 2011 when EUR/CHF reached parity.
The long-term future for EUR/CHF
The rule that new highs in EUR/USD occurs together with new lows of USD/CHF should remain for the next years. For another couple of months or maybe even 2 or 3 years, the EUR/CHF might move in tight ranges.
We judge that German inflation will move to 3% in the next 3 to 4 years (currently 1.9%). Consequently the related Swiss CPI should increase to 1.5 – 2% (currently CPI 0%, HICP 0.5%). The limited salary increases wanted by the ECB will limit inflation in France and Southern Europe to around 1.5% (currently 1.2%). During that period, ECB “forward guidance” should trigger “anti financial repression outflows” of German investors to Switzerland.
Once the forward guidance period is finished, we reckon that the SNB will hike rates more or less in line with the ECB. We are of the opinion that the Fed will not hike rates for more than five year. Jean-Pierre Danthine has already announced SNB rate hikes in a not so remote future. We see EUR/CHF falling to ranges between 1.00 and 1.10 when Swiss interest rates go up. The SNB should give up the peg when the inflation rate rises to levels around 1%; this, however, does not imply that EUR/CHF depreciates quickly to 1.10 .
Elliot wave analysis for EUR/CHF sees things similarly to us: EUR/CHF should touch 1.0075 first before finishing the wave.
FT Alphaville: Switzerland: Meet the new German Mark proxy
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