Dollar could hit 1.40 against Swissie

A recovery from a mid-cycle slowdown, a scenario the market is already starting to price in, suggests USD/CHF could have a run to 1.40 or so.

A quick glance at the bigger picture suggests all is not rosy for the greenback: bearish consensus dollar views are abundant, the currency is no longer overvalued and the path towards economic growth is littered with obstacles. Suffice to say the market dislikes the dollar as much as it did in 1995. On the other hand, strong economic data has also failed to inspire the Swiss franc. A cross-market look at the currency reveals that the odds against the Swiss franc have lengthened. Capital flows still fail to support the franc, and domestic investors are allocating funds abroad.

For the past three weeks or so, the FX market has started to price in revived global growth. Global yield curves have steepened, and the market has given up on Fed rate cut expectations as bond markets have sold off heavily. We believe global growth expectations and increasingly supportive capital flows are good reasons to look for a stronger dollar, predominantly against the Swiss franc.

When comparing yearly changes in non-farm payrolls to the Dow Jones Industrial Average in the mid-80s and mid-90s, slowing growth was followed by a period of several years of strong activity – highlighted by yearly gains in non-farm payrolls. During periods of a slowdown, stock markets rallied as earnings growth stayed strong despite slowing growth, mostly because earnings multiples improved once the Fed was no longer in tightening mode.

We draw two conclusions here. First, growth trades such as stocks but also currency pairs such as USD/JPY, EUR/CHF, AUD/CHF and CAD/CHF performed well in a slowdown scenario, historically speaking. Second, and perhaps more importantly, after such a slowdown the chances of a re-acceleration in growth seem higher than that of a downturn in activity. Such a re-acceleration bodes well for the yen, the Australian dollar and the Canadian dollar.

With rate expectations rising and the US yield curve no longer inverted, the market has started to price in a more benign growth scenario up ahead. It is also true that a change in the assessment of inflation risk is at least as important for the short-term dynamics of growth currencies and global equity markets. For now, the likelihood of ebbing inflation – a scenario supported by our global strategists – remains supportive for equity returns in the quarters ahead. However, inflation expectations need to be monitored closely.

While stock markets showed rather clear patterns in past global slowdowns ahead of a rebound in activity, the same cannot be said for the US dollar. Having weakened strongly following the Louvre Accord in the mid-80s, the greenback started to rally in the mid-90s. Currently, the dollar isn't trending, but expectations of acceleration in US growth would certainly be a surprise for most market participants, who still expect the dollar to suffer in the months ahead.

Note that after the latest, mostly firmer US economic statistics, UBS raised its real GDP growth estimate for Q2 from 2.3% to 2.8%. We have also delayed the timing and reduced the magnitude of Fed Funds rate-cut expectations. UBS expects the Fed to begin easing at the October 30/31 Federal Open Market Committee meeting, rather than at the August 8 meeting. Our investment bank economists project cumulative Fed easing of 50 basis points instead of 75, with the year-end and 2008 funds rate at 4.75% instead of the earlier projected 4.50%.

Besides a shift in the macro scenario, capital flows could also become more supportive for the dollar. We are looking at equity flows, reserve diversification by global central banks and merger and acquisition (M&A) activity.

Rising stock markets are no longer a drag on the US currency. This is at least what our Equity Flow Monitor signals. For the past five weeks, capital flows into stocks have increasingly benefited the US. At the same time, European (predominantly Swiss) equity investors have allocated money abroad with Asia-Pacific, the UK and the US being the most preferred destinations.

A major fear of market participants is that rapid global FX reserve accumulation and simultaneous rises in oil prices may push the dollar down against the Swiss franc, the euro and sterling. While we think this was the case in the first few months of the year, we see scope for reduced USD-selling reserve diversification flows as reserve accumulation by a number of key central banks slows. Russia's weekly FX reserves, which came out below its long-term average at the beginning of this month, hint at slowing diversification. Also of note, our latest M&A data is displaying renewed US asset demand – perhaps an early sign that better US growth prospects may be drawing in higher-quality capital flows to the benefit of the US dollar.

To summarise, the scenario of a rebound in economic activity in the US, a shift in capital flows out of Europe, central banks being less active in market diversification and strong M&A activity may well push the dollar higher. A stronger dollar and a continuously soft Swiss franc may well baffle consensus forecasts. In past decades USD/CHF has seen strong recoveries from the 1.20 area, so to us, 1.40 seems much more likely than dollar-Swiss parity heralded by dollar bears.