Intro to Trading the Swiss Franc

09/09/2011 6:00 am EST

Focus: FOREX

Switzerland has seemingly always had an outsized significance to the global financial community, and its currency is no exception.

The Swiss franc is the sixth-most traded currency on the foreign exchange markets, even though its economy (in nominal GDP) ranks just 19th in the world. Despite a long-held reputation for conservatism and prudence, the Swiss franc is not a common reserve currency.

The central bank behind the Swiss franc is the Swiss National Bank (SNB). As befits the country's reputation for sober and conservative economic management, the SNB does target a consistent inflation rate of around 2%. Generally speaking, the SNB does not engage in stimulative monetary policy in response to economic downturns.

The Economy Behind the Franc
Financial services make up more than 11% of Switzerland's GDP, and the country's strict policies regarding neutrality and bank secrecy have made it an exceptionally popular destination for global funds. While Switzerland has been cajoled into rolling back some of its secrecy, there are widespread rumors that as much as one-third of the world's offshore funds are held in Swiss banks.

Due in part to its neutrality and its long reputation as a banking center, the Bank for International Settlements is based in Basel.

Although Switzerland's central bank targets stability in prices, stability in growth has eluded the country. GDP growth has gone negative four times in the last 20 years, and has frequently been below 2% a year. Switzerland has indeed been quite successful at controlling inflation over the last 20 years; however, debt (as a percentage of GDP) has held steady around 55% for a number of years.

Switzerland does boast an exceptionally low rate of unemployment, and though manufacturing has been in long-term decline, the country is still competitive in some industries like chemicals, pharmaceuticals, and electric machinery.

That said, services (particularly financial services) are a major component of the economy, and a major factor in the high per-capita income of Swiss citizens.

Drivers of the Franc
Trading in the Swiss franc is certainly influenced by the global demand for Switzerland's services as a confidential offshore holding area for funds. The franc also trades as a more stable alternative to the dollar, euro, or British pound in times of turbulence and uncertainty.

While there are really not enough francs in circulation to use it as an alternative to these currencies, traders and speculators, nevertheless, seem to prefer the franc when conditions get dicey in other economies.

Carry Trade
When talking about the carry trade (which involves borrowing in a currency with low interest rates and using it to buy government debt in a currency with high rates), most of the conversation revolves around the Japanese yen. Nevertheless, the Swiss franc is also a significant player in the carry trade due to the low rates, stability, and liquidity.

Carry trades with the Swiss franc often involve the euro or pound, and traders must keep an eye on the interest rates in those areas, as they can influence demand for the franc.

Unique Factors for the Swiss Franc
Switzerland's famous neutrality is a significant factor in its economy and currency. Though Switzerland harmonizes many of its policies with the Eurozone countries, it is not a member and it maintains its independence. What's more, as a global destination of choice for expatriated capital, Switzerland is less sensitive to the economic performance of its neighbors.

Switzerland does have some risks with its heavy reliance on its banking sector. Under pressure from countries like the United States and Germany, some of Switzerland's bank secrecy laws have been relaxed. That is likely a concerning development for dictators, criminals, and businessmen who want to keep their wealth both safe and secret. As a result, other countries like Singapore have begun tightening their rules and promoting themselves as emerging alternatives to Switzerland for offshore accounts.

Another odd aspect to the Swiss franc is that, in many ways, it is a currency and not a country. While the US dollar is certainly boosted by its heavy weighting as a reserve currency and its safe haven status, trade in the dollar is still largely dictated by the economic conditions of the United States.

For the Swiss franc, it sometimes seems that only the interest-rate decisions of the SNB really matter. Perhaps this is because Swiss governments have maintained largely consistent economic policies (no one expects anything wild from the Swiss), or perhaps it is because demand for the Swiss franc is dominated more by its utility as a liquid, stable, and reliable alternative currency.

The Bottom Line
As Switzerland is not likely to move away from its conservative low-growth, low-debt philosophy and is likely to remain a key banking center, the fundamental supports for the franc seem to be firmly in place.

What's more, so long as Switzerland's policies continue to result in low rates, it is likely to remain an attractive option in carry trades and a currency with a significance far outstripping the size of its home economy.

Stephen Simpson writes for the Kratisto Investing blog.

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