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HOW OVERVALUED IS THE SWISS FRANC?

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HOW OVERVALUED IS THE SWISS FRANC?

Stefan Gerlach, Chief Economist at EFG Bank, argues that changes in the real exchange rate of the Swiss franc do not, in themselves, determine the degree of overvalution…

After the SNB abandoned the exchange rate floor of 1.2 CHF per euro in January 2015, the Swiss franc appreciated sharply. Between the end of December 2014 and the end of May 2015 it rose by 14%. Of course, it had appreciated strongly already in the years before. Overall, from the end of August 2008, the month before the collapse of Lehman Brothers that triggered the financial crisis, to the end of May 2015, the Swiss franc appreciated by 36% against the euro. However, between May 2015 and December 2017 it depreciated 11% against the euro.

But is the Swiss franc overvalued now? To think about that question it is helpful to make a distinction between bilateral and effective exchange rates, between nominal and real exchange rates and to consider the uncertainty that surrounds the “equilibrium” real exchange rate.

Some exchange rate concepts

While the euro area is Switzerland’s single largest export market, exports to other economies are also important.

In assessing whether the Swiss franc is overvalued it is therefore not sufficient to look solely at the bilateral exchange rate to the euro. One should also look at theexchange rate against Switzerland’s trading partners more generally, that is, at the effective exchange rate of the Swiss franc.

Furthermore, since exchange rates often move to offset inflation differentials, it is helpful to look at the real effective exchange rate, which captures the relative price of Swiss goods and services against a broad set of countries. It can be computed by multiplying the nominal effective exchange rate of the Swiss franc with the Swiss CPI, and dividing by the consumer price indices in Switzerland’s trading partners.[1]

Figure 1. shows that both the nominal and real exchange rates of the Swiss franc appreciated over the period 1973- 2017.[2] The two exchange rates are export-weighted, that is, they are effective exchange rates. Between December 2014 and May 2015, the real effective exchange rate rose by 11%. The total real appreciation from August 2008 to May 2015 was 29%. Between May 2015 and December 2017, however, the Swiss franc depreciated by 10% in real effective terms.

As can be seen in the figure, over short periods of time, changes in the real exchange rate are dominated by changes in the nominal exchange rate. The reason for this is that the Swiss and foreign price levels evolve only slowly. Thus, while the exchange rate can change by a few percentage points in a day, price indices typically change by a few percent in a year.

When talking about exchange rate changes over a month or even a few years, there is therefore little to be gained in making a distinction between real and nominal exchange rates. But over longer time horizons the distinction becomes important; the figures show that the real exchange rate of the Swiss franc has appreciated much less than the nominal exchange rate.

While monetary policy strongly influences the real exchange rate in the short-term, it has no impact over longer periods of time. The reason is that it has two offsetting effects. While tight monetary policy leads the Swiss franc to strengthen, after some time it also reduces Swiss inflation. The effects of monetary policy therefore wash out.

Figure 1. shows that the Swiss real exchange rate appreciated from an index value of 72 in January 1973 to a value of 112 in December 2017, or by about 56% (or by 1.3% per year). If monetary policy does not explain that appreciation, what does?

Since the real exchange rate is a relative price, it is determined by the same factors as other relative prices – changes in demand patterns. Thus increases in the demand for Swiss goods and services will tend to appreciate the real exchange rate. Switzerland exports high-end products, ranging from watches to specialty chemicals, whose demands tend to increase strongly as world income rises. Furthermore, these goods are relatively price-insensitive. It is therefore natural to expect the Swiss franc to appreciate over time.[3]

Is the Swiss franc overvalued?

Is the Swiss nominal exchange rate too high, given prices in Switzerland and in the rest of the world? To answer that question, it is necessary to form a view about the “equilibrium” real exchange rate. Unfortunately, that level is unknown and must be estimated. One way to do so is to fit a statistical model to the real exchange rate and compare the current level with forecasts made in the past (since such forecasts will settle at the equilibrium level after any temporary dynamics have worked themselves out).

Figure 2. provides the results of such an exercise. Here a simple model of the real exchange rate is estimated on data from 1973 to 2006. The model assumes that the equilibrium real exchange rate follows a linear trend, and thus implies that the Swiss franc is expected to continue to appreciate in real terms in the future. If the actual real exchange rate deviates from the equilibrium level, it is expected to revert to the equilibrium level. It is worth pointing out that this approach assumes that on average over the estimation period the exchange rate was at the equilibrium level.

Next the model is used to forecast the real exchange rate over the period January 2007 until the end of 2017. Since the equilibrium level is estimated, it is subject to some uncertainty. To assess the degree of uncertainty an approximate 70% confidence band is plotted.

The figure shows that the real exchange rate was quite weak at the end of 2006. Consequently, forecasts made at that time suggested that it would strengthen quite quickly towards the equilibrium level, and subsequently appreciate further together with the equilibrium level.  At the end of the sample, in December 2017, the actual real exchange rate index is 112.1 and the equilibrium level is estimated to be 107.1, with a 70% confidence band of 100.6 – 113.9.

Overall, these results suggest that while the real exchange rate is about 5% stronger than the estimated equilibrium level, it is well within the margin of uncertainty surrounding the equilibrium real exchange rate.

Conclusions

The Swiss exchange rate appreciated strongly after the SNB abandoned the floor against the euro in early 2015. While this was a complication for Swiss exporters and the Swiss tourist industry, the Swiss franc has historically been appreciating. Furthermore, the real exchange rate of the Swiss franc – the relative price of goods and services in Switzerland – has also increased gradually over time, although a slower pace.

But looking at changes in the exchange rate is not enough to determine if the Swiss franc is overvalued. To do so, the real exchange rate must be compared to its “equilibrium” level, which must be estimated. It appears that in December 2017 the Swiss franc was a little overvalued, but not so much as to be outside the margin of error that is inherent in the estimation.

[1] The real exchange, Q equals E × P/P* where E denotes the price of the Swiss franc, P the Swiss consumer price index and P* the foreign price index.

[2] The real exchange rate is measured using consumer prices and is against Switzerland’s 24 most important export markets.

[3] Another reason is that Switzerland has a large service sector which naturally displays a higher inflation rate than the goods sector since productivity growth in services is lower.

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How has the online trading landscape changed in 2020?

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How has the online trading landscape changed in 2020? 1

By Dáire Ferguson, CEO, AvaTrade 

This year has been all about change following the outbreak of coronavirus and the subsequent global economic downturn which has impacted nearly every aspect of personal and business life. The online trading world has been no exception to this change as volatility in the financial markets has soared.

Although the global markets have been on a rollercoaster for some time with various geopolitical tensions, the market swings that we have witnessed since March have undoubtedly been unlike anything seen before. While these are indeed challenging times, for the online trading community, the increased volatility has proven tempting for those looking to profit handsomely.

However, with the opportunity to make greater profits also comes the possibility to make a loss, so how has 2020 changed the online trading landscape and how can retail investors stay safe?

Lockdown boost

Interest rates offered by banks and other traditional forms of consumer investments have been uninspiring for some time, but with the current economic frailty, the Bank of England cut interest rates to an all-time low. This has left many people in search of more exciting and rewarding ways to grow their savings which is indeed something online trading can provide.

When the pandemic hit earlier this year, it was widely reported that user numbers for online trading rocketed due to disappointing savings rates but also because the enforced lockdown gave more people the time to learn a new skill and educate themselves on online trading.

Dáire Ferguson

Dáire Ferguson

A volatile market certainly offers great scope for profit and new sources of revenue for those that are savvy enough to put their convictions to the test. However, where people stand the chance to profit greatly from market volatility, there is also the possibility to make a loss, particularly for those that are new to online trading or who are still developing their understanding of the market.

The sharp rise in online trading over lockdown paired with this year’s unpredictable global economy has led to some financial losses, but with a number of risk management tools now available this does not necessarily have to be the case.

Protect your assets

Although not yet widely available across the retail market, risk management tools are slowly becoming more prevalent and being offered by online traders as an extra layer of security for those seeking to trade in riskier climates.

There are a range of options available for traders, but amongst the common tools are “take profit” orders in conjunction with “stop loss” orders. A take profit order is a type of limit order that specifies the exact price for traders to close out an open position for a profit, and if the price of the security does not reach the limit price, the take profit order will not be fulfilled. A stop loss order can limit the trader’s loss on a security position by buying or selling a stock when it reaches a certain price.

Take profit and stop loss orders are good for mitigating risk, but for those that are new to the game or who would prefer extra support, there are even some risk management tools, such as AvaProtect, that provide total protection against loss for a defined period. This means that if the market moves in the wrong direction than originally anticipated, traders can recoup their losses, minus the cost of taking out the protection.

Not a day has gone by this year without the news prompting a change in the financial markets. Until a cure for the coronavirus is discovered, we are unlikely to return to ‘normal’ and the global markets will continue to remain highly volatile. In addition, later this year we will witness one of the most critical US presidential elections in history and the UK’s transition period for Brexit will come to an end. The outcome of these events may well trigger further volatility.

Of course, this may also encourage more people to dip their toes into online trading for a chance to profit. As more people take an interest and sign up to online trading platforms, providers will certainly look to increase or improve the risk management tools on offer to try and keep new users on board, and this could spell a new era for the online trading world.

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Trading Strategies

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Trading Strategies 2

By Paddy Osborn, Academic Dean, London Academy of Trading

Whether you’re negotiating a business deal, playing a sport or trading financial markets, it’s vital that you have a plan. Top golfers will have a strategy to get around the course in the fewest number of shots possible, and without this plan, their score will undoubtedly be worse. It’s the same with trading. You can’t just open a trading account and trade off hunches and hopes. You need to create a structured and robust plan of attack. This will not only improve your profitability, but will also significantly reduce your stress levels during the decision-making process.

In my opinion, there are four stages to any trading strategy.

S – Set-up

T – Trigger

E – Execution

M – Management

Good trading performance STEMs from a structured trading process, so you should have one or more specific rules for each stage of this process.

Before executing any trades, you need to decide on your criteria for making your trading decisions. Should you base your trades off fundamental analysis, or maybe political news or macroeconomic data? If so, then you need to understand these subjects and how markets react to specific news events.

Alternatively, of course, there’s technical analysis, whereby you base your decisions off charts and previous price action, but again, you need a set of specific rules to enable you to trade with a consistent strategy. Many traders combine both fundamental and technical analysis to initiate their positions, which, I believe, has merit.

Set-up

What needs to happen for you to say “Ah, this looks interesting! Here’s a potential trade.”? It may be a news event, a major macro data announcement (such as interest rates, employment data or inflation), or a chart level breakout. The key ingredient throughout is to fix specific and measurable rules (not rough guidelines that can be over-ridden on a whim with an emotional decision). For me, I may take a view on the potential direction of an asset (i.e. whether to be long or short) through fundamental analysis, but the actual execution of the trade is always technical, based off a very specific set of rules.

To take a simple example, let’s assume an asset has been trending higher, but has stopped at a certain price, let’s say 150. The chart is telling us that, although buyers are in long-term control, sellers are dominant at 150, willing to sell each time the price touches this level. However, the uptrend may still be in place, since each time the price pulls back from the 150 level, the selling is weaker and the price makes a higher short-term low. This clearly suggests that upward pressure remains, and there’s potential to profit from the uptrend if the price breaks higher.

Trigger

Once you’ve found a potential new trade set-up, the next step is to decide when to pull the trigger on the trade. However, there are two steps to this process… finger on trigger, then pull the trigger to execute.

Paddy Osborn

Paddy Osborn

Continuing the example above, the trigger would be to buy if the price breaks above the resistance level at 150. This would indicate that the sellers at 150 have been exhausted, and the buyers have re-established control of the uptrend.  Also, it is often the case that after pause in a trend such as this, the pent-up buying returns and the price surges higher. So the trigger for this trade is a breakout above 150.

Execution

We have a finger on the trigger, but now we need to decide when to squeeze it. What if the price touches 150.10 for 10 seconds only? Has our resistance level broken sufficiently to execute the trade? I’d say not, so you need to set rules to define exactly how far the price needs to break above 150 – or for how long it needs to stay above 150 – for you to execute the trade. You’re basically looking for sufficient evidence that the uptrend is continuing. Of course, the higher the price goes (or the longer it stays above 150), the more confident you can be that the breakout is valid, but the higher price you will need to pay. There’s no perfect solution to this decision, and it depends on many things, such as the amount of other supporting evidence that you have, your levels of aggression, and so on. The critical point here is to fix a set of specific rules and stick to those rules every time.

Management

Good trade management can save a bad trade, while poor trade management can turn an excellent trade entry into a loser. I could talk for days about in-trade management, since there are many different methods you can use, but the essential ingredient for every trade is a stop loss. This is an order to exit your position for a loss if the market doesn’t perform as expected. By setting a stop loss, you can fix your maximum risk on a trade, which is essential to preserving your capital and managing your overall risk limits. Some traders set their stop loss and target levels and let the trade run to its conclusion, while others manage their trades more actively, trailing stop losses, taking interim profits, or even adding to winning positions. No matter how you decide to manage each trade, it must be the same every time, following a structured and robust process.

Review

The final step in the process is to review every trade to see if you can learn anything, particularly from your losing trades. Are you sticking to your trading rules? Could you have done better? Should you have done the trade in the first place? Only by doing these reviews will you discover any patterns of errors in your trading, and hence be able to put them right. In this way, it’s possible to monitor the success of your strategy. If your trades are random and emotional, with lots of manual intervention, then there’s no fixed process for you to review. You also need to be honest with yourself, and face up to your bad decisions in order to learn from them.

In this way, using a structured and robust trading strategy, you’ll be able to develop your trading skills – and your profits – without the stress of a more random approach.

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Economic recovery likely to prove a ‘stuttering’ affair

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Economic recovery likely to prove a ‘stuttering’ affair 3

By Rupert Thompson, Chief Investment Officer at Kingswood

Equity markets continued their upward trend last week, with global equities gaining 1.2% in local currency terms. Beneath the surface, however, the recovery has been a choppy affair of late. China and the technology sector, the big outperformers year-to-date, retreated last week whereas the UK and Europe, the laggards so far this year, led the gains.

As for US equities, they have re-tested, but so far failed to break above, their post-Covid high in early June and their end-2019 level. The recent choppiness of markets is not that surprising given they are being buffeted by a whole series of conflicting forces.

Developments regarding Covid-19 as ever remain absolutely critical and it is a mixture of bad and good news at the moment. There have been reports of encouraging early trial results for a new treatment and potential vaccine but infection rates continue to climb in the US. Reopening has now been halted or reversed in states accounting for 80% of the population.

We are a long way away from a complete lockdown being re-imposed and these moves are not expected to throw the economy back into reverse. But they do emphasise that the economic recovery, not only in the US but also elsewhere, is likely to prove a ‘stuttering’ affair.

Indeed, the May GDP numbers in the UK undid some of the optimism which had been building recently. Rather than bouncing 5% m/m in May as had been expected, GDP rose a more meagre 1.8% and remains a massive 24.5% below its pre-Covid level in February.

Even in China, where the recovery is now well underway, there is room for some caution. GDP rose a larger than expected 11.5% q/q in the second quarter and regained all of its decline the previous quarter. However, the bounce back is being led by manufacturing and public sector investment, and the recovery in retail sales is proving much more hesitant.

China is not just a focus of attention at the moment because its economy is leading the global upturn but because of the increasing tensions with Hong Kong, the US and UK. UK telecoms companies have now been banned from using Huawei’s 5G equipment in the future and the US is talking of imposing restrictions on Tik Tok, the Chinese social media platform. While this escalation is not as yet a major problem, it is a potential source of market volatility and another, albeit as yet relatively small, unwelcome drag on the global economy.

Government support will be critical over coming months and longer if the global recovery is to be sustained. This week will be crucial in this respect for Europe and the US. The EU, at the time of writing, is still engaged in a marathon four-day summit, trying to reach an agreement on an economic recovery fund.  As is almost always the case, a messy compromise will probably end up being hammered out.

An agreement will be positive but the difficulty in reaching it does highlight the underlying tensions in the EU which have far from gone away with the departure of the UK. Meanwhile in the US, the Democrats and Republicans will this week be engaged in their own battle over extending the government support schemes which would otherwise come to an end this month.

Most of these tensions and uncertainties are not going away any time soon. Markets face a choppy period over the summer and autumn with equities remaining at risk of a correction.

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