Chuck Butler on the Swiss Franc and potential end of the carry trade, from his must-read currency newsletter, the Daily Pfennig:
Swiss inflation is really putting the pressure on the Swiss National Bank (SNB) to raise interest rates… Inflation in Switzerland accelerated faster than expected in March. In fact, it was the fastest monthly pace in 14 years! OK, get ready for this… Because from that introduction, you would think inflation was out of control here, right? Well… Inflation rose to 2.6%… Nonetheless, this is higher than the SNB’s target of 2%… So… Hopefully the SNB will not rely strictly on the stronger franc to combat this rise in inflation… A rate hike in Switzerland could all but end the short selling in francs…
Why you ask? Ahhh grasshopper, sit… You, see… When a low yielding currency is used as the funding currency of the Carry Trade, it is sold “short”, and the proceeds are used to purchase a higher yielding currency… Since the “short” currency’s yields are low, the borrowing costs are low too… (when you sell short, someone has to lend it to you to sell, thus you are borrowing the currency)… But if the borrowing costs begin rise, that causes the trade to lose… And who wants a “losing” trade?
So… Grasshopper… If Switzerland’s interest rates would go higher, their borrowing costs would go higher. This would cause the Carry Trades using Swiss francs as a funding currency to unwind, which means the “short” would get covered, and to cover a short… You BUY the currency! Thus driving the price of Swiss francs higher! YAHOO! That’s it… That’s all there is!