USD/CHF 2% Undervalued, Could be Ripe for a 'Carry Trade' Opportunity

- USD/CHF looks like it is bottoming and about to reverse trend

- USD interest rates offer higher returns than Swiss rates and are a draw

- Trading the pair as a 'carry trade' offers both interest and exchange rate potential

© Andrey Popov, Adobe Stock

The US Dollar could be bottoming against the Swiss Franc according to recent analysis from Julius Baer who see USD/CHF as a new carry trade opportunity noting the the interest rate differential between the US and Switzerland is widening (currently 1.75% vs -0.75%).

A carry trade sees investors borrow money in a low interest rate currency and then invest the funds in a higher interest rate account, creating a demand for currency in which to carry out the investment. The difference between what the investor has to pay to service his debt and the interest earned is the profit.

In this case, investors borrow in Francs and buy Dollar-denominated assets that offer an higher return, the trade therefore creates demand for USD at the expense of CHF.

Backing the call for an higher USD/CHF over coming weeks is the view that the Dollar might now be overly 'undervalued' againt its Swiss counterpart.

Looking at the markets, USD/CHF is 4.0% down on its peak in 2012 whilst carry profits are up 2.0 %.

Given the assumption that the exchange rate will fall to discount the carry, USD/CHF would have been expected to fall exactly 2.0% - not 4.0%.

The inference is that USD/CHF is at least 2.0% undervalued - at least on a carry basis - and is, therefore, likely to rise to erase this 'mispricing'.

"Looking at the USD/CHF chart we see that we are trading 4% below the peak of 2012," says Mensur Pocinci, an analyst at Julius Baer.

The potential carry profit, or 'total return' however, is only 2.0% higher.

"In contrast, looking at the total return calculation i.e. investing for three months in the US Dollar money market versus three months in the Swiss franc money market, we see that it is actually 2% above the peak of 2012," says the analyst

It is not just short-term carry which is showing potential. Pocinci highlights how historically the pair has generated returns in excess of expectations.

"From March 1995 to May 2001, the USD/CHF carry return almost doubled by rising 97% or 11% per annum," says the analyst.

And whilst Julius Baer are not forecasting the exact same thing from happening again, they note that "long-term momentum is bottoming again and we give the US dollar the benefit of doubt."

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