The Australian dollar has been declining against the Swiss franc for some time. Might the pair have found a bottom, finally? The chart below illustrates the price action of the AUD/CHF currency pair since 1992. This also includes the most recent price action, which has the pair trading in the region of 0.65 to 0.69.

(Chart created by the author using TradingView. The same applies to subsequent candlestick charts presented herein.)

Currencies are generally guided by interest rates, or more specifically interest rate differentials. A country’s interest rates, in turn, are influenced by the state of the country’s economy. The more sound the economy, the greater the probability that interest rates will rise. The opposite is the case: a weaker economy usually gives rise to lower rates, as looser monetary policy is justified to help support economic growth and activity.

The table below lists the rates of major central banks across the world. The short-term rates as set by the Reserve Bank of Australia, or RBA, and the Swiss National Bank, or SNB, are highlighted. Central bank rates are effectively the rates at which central banks charge on their loans and advances to commercial banks. These rates tend to feed through into the general economy, through the banking system.

Central Bank Rates(Table source: Investing.com.)

As rates fall, money becomes cheaper and hence more “liquid” (if all goes to plan), whereas the financial system can tighten up when money becomes dearer (more expensive, through higher rates). However, most importantly, currency markets tend to favor currencies that produce high yields relative to other currencies, while additionally showing sustainability with respect to those higher yields.

The problem with the Swiss franc is that there is simply a lack of inflation. The unprecedentedly low interest rates in the country as shown in the table (the short-term rate has been set at a negative -0.75%) has not managed to pull the country out of low inflation (and/or deflation). The table below from Trading Economics shows Switzerland’s year-on-year inflation rate since January 2015, the month in which the SNB lowered its rate to -0.75% (from -0.25%, previously).

Switzerland Inflation Rate

As you can see from the chart, although the year-on-year inflation rate proceeded to drop into deflationary territory through 2015 and 2016, the inflation rate was able to pick up into positive territory through 2017 and 2018, and even much of 2019. However, since late 2018, the inflation rate has been ticking down, and most recently, it has been in negative territory (i.e., the country is showing deflationary pressure) in October and November of 2019.

In other words, it does not appear that the SNB can raise rates from the negative -0.75% rate as at present. This is especially bad given that the rate has been so negative for so long, approaching five years, and yet the country is returning to the same problem as before.

Australia’s inflation rate, on the other hand, is better. The chart below is also from Trading Economics for the same period (since January 2015). The chart shows year-on-year inflation on a quarterly basis (rather than monthly basis as in the prior chart for Switzerland).

Australian Inflation Rate

As shown above, the annual inflation rate has been steadier. The RBA’s target for inflation is between 2 and 3%, which might suggest room for the country to ease rates further given that the above figures fall short. However, given that inflation is low across the world, and given that the inflation rate is most recently showing signs of improvement (moving toward the 2% level on an annual basis), it is probably unlikely that Australia will ease any time soon.

The RBA’s current rate of +0.75% is also not too from the zero bound (i.e. 0.00%), hence the RBA will also likely want to remain cautious so that if a downturn were to occur, they would be better equipped to ease sustainably (avoiding exhausting all their “monetary policy ammo”, so to speak, too soon).

Therefore, what we have is a situation where Australian rates are likely to remain stable for the time being, with some risk of easing, whereas Swiss rates are likely to remain in their currently negative territory of -0.75%, exactly where they have been since January 2015.

The spread between these two rates is +1.50% (i.e., +0.75% minus -0.75%, which sums to +1.50%). This positive spread makes it attractive to hold Australian dollars in terms of Swiss francs, from a carry-trade perspective (the spread provides traders with interest income).

We can also cross-reference this spread with the bond market, as below, which shows the spread between the one-year interest rates offered by Australian bonds and Swiss bonds. The chart below uses the same period from January 2015 to present (created by the author).

Aussie-Swiss One-year Bond Yield Spread

As we can see, the spread matches up perfectly with the central bank rate spread. At this point in time, we may find greater volatility in the AUD/CHF pair. It would take a stream of significant, positive economic data and news out of Switzerland to support a stronger Swiss franc, in light of how negative rates are in Switzerland.

Australia, on the other hand, will need to show continued strength. But if it can continue to post stable inflation, preferably over 1.5% (and even better, over 1.7% next quarter), we could see the AUD/CHF rise from current levels. With the Swiss franc facing naturally heavy pressure (due to negative rates, making it an attractive currency to sell-short) combined with a Swiss National Bank that is open to devaluing the currency (as I previously spoke about), any positive news from Australia (or even further stability) will help position this pair for upside.

It would appear that the yield spread, as shown in the chart above (with the red line), has simply been playing “catch up”. Since currencies tend to follow spreads, we might infer that there is a possibility that a bottom has now been found. Further downside in AUD/CHF spot prices is probably limited at this point.

AUD/CHF Trading Range

As per the chart above, we might expect AUD/CHF to continue to trade in the current long-term trading range (shaded in grey) of about 0.6550 to 0.7810, with a cautiously optimistic bias; 0.7810 could be next, rather than much further downside. We should watch and wait for more economic data.

Follow me on Seeking Alpha if you would like further updates.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source link

2019-12-07