Increased SNB concern about CHF weakness

Since 2006, EURCHF has moved from 1.542 to a high of 1.6673. As a low-yielding currency, the Swiss franc is a favorite funding currency for carry trades. In UBS Research view, the current CHF weakness is mainly the result of very low investor risk aversion, facilitating carry trades. The Swiss National Bank (SNB) has recently reacted to this weakness, taking the unusual measure of aggressively raising repo rates to support the CHF in between meetings. “We expect the SNB to continue defending the CHF, but only to prevent it from reaching new lows,” note UBS analysts in the UBS Investor’s guide report, dated July 6, 2007.

After EURCHF bounced above 1.66, the SNB started actively to intervene in the repo

market by hiking interest rates twice on June 20 and June 22. This and an increase in investors’ risk aversion pushed EURCHF to 1.65. At the same time 3-month CHF Libor, the SNB target rate, moved rapidly up to 2.69%, far away from 2.50% – the middle of the SNB target range. Although some market participants now expect a 50 bp hike at the next SNB meeting in September 2007 or an intra-meeting rate adjustment, the SNB will have to take further steps such as additional increases in the repo rate to justify such expectations. UBS analysts still assume that the SNB will disappoint the current high market expectations by increasing interest rates by only 25bp in September. This will put downward pressure on the CHF.

As the current risk loving environment will in our view persist in the short term,

EURCHF will move up again and retest the level of 1.66. We expect the SNB to intervene in repo markets when EURCHF breaches 1.66, preventing it from reaching 1.68. SNB President Roth affirmed that further action will follow if the CHF weakens again. Should CHF three-month Libor continue its upward movement to above 2.75%, a new assessment from the SNB regarding the current value of 3m-Libor is likely, as it would then no longer be in the middle of the SNB target range. Given the SNB’s action UBS analysts expect the upside in EURCHF to be capped at 1.68.