Prediction is very difficult, especially about the future. This adage also applies to Swiss franc interest rates. For several years, people have increasingly been talking about historic lows. We may have moved away slightly from the absolute lows seen at the end of last year. But since then the interest rate curve has continued to be relatively flat, as measured by the difference between ten-year and two-year Swiss federal bonds.
Interest Rates Low – Equity Markets Set for Recovery
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Between the beginning of 2010 and the middle of 2012, there appears to have been a connection between Swiss franc interest rates and the local equity market: If yields from ten-year Swiss federal bonds are compared with the Swiss Market Index (SMI), it can be seen that they moved in parallel (see chart). But since last summer, they have diverged sharply. While interest rates have stabilized at a low level, equity markets are signaling an economic recovery.
Equity Markets Buoyant
With the announcement that it is to buy government bonds in the secondary market with a term to maturity of up to three years, and with Mario Draghi’s speech declaring that the euro was irreversible, the European Central Bank (ECB) boosted equity markets. In addition, positive data is coming out of the US, such as falling unemployment and rising house prices, which is also fueling the equity markets. US businesses are reporting positive numbers, have sufficient liquidity, and are publishing healthy balance sheets. US banks are better capitalized than before the start of the financial crisis.
Switzerland: Economic Data Points to a Moderate Economic Recovery
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By GlobalDataIn Switzerland too, the major leading economic indicators point to a moderate economic recovery. On the strength of stable macro data, interest rates could move further away from the extreme lows. But for a number of months, the interest rates on ten-year Swiss federal bonds have been in a relatively narrow band between a low 0.6 percent and 0.8 percent. This is because the Swiss franc and interest rates are largely determined by factors outside the country. For this reason, the Swiss National Bank (SNB) drew attention to considerable downside risks – consisting of increasing political, fiscal and economic uncertainties within Europe and the euro zone – during its monetary policy assessment in March.
Political Instability in the Euro Zone Threatens Switzerland
Because Switzerland is a small but open economy, Swiss franc interest rates react sharply to external factors such as the outcome of elections in a neighboring country. Political instability in the euro zone represents a serious potential threat to Switzerland. Moreover, a certain austerity fatigue is detectable in highly indebted countries in the euro zone. The economic situation in Europe is characterized by recession and high unemployment. Such uncertainties dampen the mood on the bond markets and lead to a flight into safe havens such as the Swiss franc. In contrast with many other countries, short-term Swiss government bonds can be regarded as risk free, not least because of healthy state finances. The bond market in Switzerland traditionally exhibits above-average creditworthiness among borrowers. The continuing negative yields at the short end point to the nervous mood in the capital market and to fears that the crisis could worsen further.
No Risk of Inflation in Sight
Will interest rates remain so low despite the robust domestic economy? Owing to falling costs of imports and the difficult economic situation in the euro zone, the SNB continues to see no risk of inflation. The expansive monetary policy may well be a good thing for the equity markets. But it is only when the banks provide businesses with more credit that money starts to flow into the real economy and have an inflationary effect. This is because inflation is caused by higher demand, among other things. However, there is no prospect of higher demand from the euro zone due to the economic situation. It is unlikely that the ECB will increase interest rates in the foreseeable future. As long as the unemployment rate in the US remains above 6.5% and inflation does not become a significant issue for the country, it is also not anticipated that the US Federal Reserve will alter its expansive interest rate policy.
Future Prospects
In order to counter low interest rates, some investors are adding longer-dated bonds to their portfolios. But this increases the interest rate risk, of course. With variable interest bonds, so-called floaters, investors can hedge against rising interest rates. In order to improve the yields of a portfolio even further, investors increasingly choose corporate bonds with lower rating quality. Issues for the future could be the way in which the debt crisis in the euro area can be overcome in the long term, as well as the exit strategies of the Central Banks, which have flooded the financial markets with liquidity. In addition, there is likely to be increasing focus on emerging markets, as well as the question as to how long growth will continue there.
