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 the marginal
buyer of global equities.  They sell dollars and buy foreign equities, and
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 generate a higher yield than being 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 looks better? 

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.  A carry trade is a trade in which one expected to
profit from the interest rate differential.  That is the carry. 

However, it is often poorly understood.   
Consider that currently, one can borrow yen for about -3  bp annualized
for three months.  That yen can then
sold, and dollars bought and put in a
three-month time deposit and earn 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 a bit closer at that carry, 125
bp annualized.
  That turns out to be about 10.5 bp a month.  This year, the dollar has moved on averaged
almost 1.3% a month so far this year.    On the other hand, the
euro rose around 14.5% against 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. 

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, as we have shown, is
frequently too great to make a carry strategies practical.
  The issue
is then which currency is a better funding currency now the yen or the 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 today. 
Three-month yen LIBOR was fixed at about minus three bp today. 
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.  Yesterday’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.  

Disclaimer

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