Is The Yen Or Swiss Franc A Better Funding Currency?

Retail investors and some institutional investors focus on the asset they want to acquire in anticipation of price appreciation. The game for some institutional investors is more complicated. It is not only about the asset that is to be purchased, but it is also about how the purchase is funded. A low-returning asset is a drag, but if the funding costs can be reduced, a low-returning asset may still be attractive.

In the capital markets, securing cheap funding is accomplished by selling a low-yielding (and ideally a low-volatility) instrument and using the proceeds to purchase a higher-yielding or a better-performing asset. In the foreign-exchange market, the dollar is the ultimate funding currency. Americans are marginal buyer of global equities. They sell dollars and buy foreign equities, largely on an unhedged basis. Foreign companies and countries borrow dollars and frequently convert the proceeds back to their own currency.

Levered accounts often use the Japanese yen and/or Swiss franc as funding currencies. That is to say, those currencies are borrowed and then sold to buy another asset that is expected to generate a higher yield than that paid for the funding. In times of heightened anxiety or a spike in volatility, the trade is unwound, which is to say that the purchased asset is liquidated and the funding is replaced (bought back). That is precisely what appears to have happened last week as the bellicose rhetoric over North Korea escalated. And it was the yen and franc's weakness before the weekend, which we saw as a tell that the market's focus was going to shift away from the Korea story.

If the geopolitical anxiety is easing, and the chances that Draghi breaks new ground at Jackson Hole next week, is it a safe time to look at the funding currencies and if so, which ones look best? To be sure, when a low-yielding instrument is sold for an asset that is expected to offer a higher return, it is often called a 'carry trade,' which expects to profit from the interest-rate differential. That's the carry.

However, it is often poorly understood. Consider that one can now borrow yen for about -3 bp annualized for three months. That yen can then be sold, as dollars are bought and held in a three-month time deposit, earning about 130 bp annualized for the three months. One earns 133 bp over the three months adjusted for the change in the value of the yen over that period. Over the past three months, the yen has gained 2% (not annualized), which is some multiple of the carry earned.

Moreover, look closer at that carry, which is 125 bp annualized. That turns out to be about 10.5 bp a month. This year, the dollar has moved on average almost 1.3% a month. On the other hand, the euro rose around 14.5% against the dollar from mid April to early August. The carry earned is overwhelmed by the price appreciation. Some participants may have bought the euro for yen and said it was about the carry, but it was really a momentum trade.

Get The News You Want

Read market moving news with a personalized feed of stocks you care about.

Get The App

To reiterate, the use of the Swiss franc and Japanese yen as a funding currency is not limited to the currency market, where the volatility is frequently too great to make a carry strategies practical. The issue is then which currency is the better funding vehicle — the yen or Swiss franc.

The Swiss franc offers more negative short-term interest rates and is less volatile than the yen. Specifically, three-month franc LIBOR was fixed at minus 72.5 bp on Wednesday. Three-month yen LIBOR was fixed at about minus three bp. Three-month implied volatility is 7.5% annualized for the Swiss franc and 8.7% for the yen. Both countries are experiencing little price pressures. Japan's July headline CPI was 0.4% year-over-year, while Swiss inflation was 0.3% (0.6% in the EU harmonized methodology). The Swiss economy growth is weaker but less volatile than Japan. Japan's economy grew 1.0% in Q2 after 0.4% growth in Q1. The Swiss economy grew by 0.3% in Q1. When it reports Q2 GDP in early September, it is expected to have risen by around 0.5%.

On balance, these fundamental considerations suggest that the Swiss franc may be a better funding currency now than the yen. Technical considerations suggest some caution. The franc has depreciated by around 5% against the yen between July 10 and this past Monday. This left the technical indicators a bit stretched. Tuesday's big advance of the franc over the yen helped lift the RSI and the Slow Stochastics have already turned up. Minor bullish divergences are evident. The MACDs look poised to cross higher before the weekend.

The cross fell into the lower end of the range seen in the second half of Q2 (~JPY112.50). A move above JPY114.30 (last week’s high) is needed to confirm a franc low is in place. The JPY114.65-JPY114.75 area houses the 38.2% retracement objective of the last leg down that began on July 25 near JPY118 and the 20-day moving average. The franc has not closed above its 20-day moving average against the yen since July 21.

Written By: Marc Chandler