Following the Japanese Yen, another large arbitrage trade may be on the verge of "exploding"!

Despite investors turning to the Swiss Franc as a substitute for the Japanese Yen to provide funding for arbitrage trades, the risk of a rapid rebound in this currency always exists. The Swiss Franc has long been used in this popular strategy, where traders borrow low-interest currencies and then exchange them for other currencies to purchase higher-yielding assets. With the diminishing attractiveness of the Japanese Yen, the appeal of using the Swiss Franc for arbitrage trading has further strengthened. In August, due to weak U.S. economic data and an unexpected rate hike by the Bank of Japan, the Yen arbitrage trade collapsed, leading to a significant rebound in the Yen and causing turmoil in global markets. The Swiss National Bank (SNB) was the first major central bank to initiate a loose cycle earlier this year, with a key interest rate of 1.25%, allowing investors to borrow Swiss Francs at low cost to invest elsewhere. In comparison, interest rates in the U.S. range from 5.25% to 5.50%, 5% in the U.K., and 3.75% in the Eurozone. "The Swiss Franc has become a funding currency again," said Benjamin Dubois, Global Head of Coverage Management at Edmond de Rothschild Asset Management Switzerland. Stability The Swiss Franc to U.S. Dollar exchange rate is at its highest level in 8 months, and the Euro exchange rate is at its highest level in 9 years, reflecting its status as a safe-haven currency and expectations of rate cuts in Europe and the U.S. However, investors hope that the value of the currency will gradually decline, which would increase the returns of arbitrage trades. Data from the U.S. Commodity Futures Trading Commission (CFTC) shows that despite speculators suddenly shifting to holding $2 billion long positions on the Yen, they still hold $3.8 billion short positions on the Swiss Franc. Analysts generally believe that the large amount of short positions is a sign that the currency is being used to provide funding for arbitrage trades. "Compared to before, now there is greater two-way risk with the Yen," said Kamal Sharma, G10 FX strategist at Bank of America. "The Swiss Franc seems like a more reasonable funding currency choice." Bank of America recommends investors to buy the Pound against the Swiss Franc, citing the significant interest rate differential between Switzerland and the U.K. that could lead to a rise in the Pound, with Goldman Sachs expressing a similar view. As inflation weakens, the Swiss National Bank appears likely to further cut rates in the coming months. This would lower the borrowing cost of the Swiss Franc and potentially put pressure on the currency, making it easier for those who have borrowed Swiss Francs to repay. The Swiss National Bank also seems unwilling to see the currency strengthen further, partly because it would cause pain for exporters. Bank of America and Goldman Sachs indicate that they believe the Swiss National Bank intervened in August to weaken the currency. Michael Cahill, G10 currency strategist at Goldman Sachs, stated: "The Swiss National Bank may intervene or cut rates to prevent currency appreciation." "Inherent Risks" However, the Swiss Franc may be an unreliable "friend." Due to the Swiss Franc's long-standing reputation as a safe-haven currency, investors often rush to buy the currency when they feel nervous. Cahill suggests that the Swiss Franc is best used as a funding currency during times when investors are feeling optimistic. ** The rapid rebound of currencies used to provide funds for arbitrage trading can quickly erase investors' profits and lead to rapid liquidation, as demonstrated by the dramatic performance of the Japanese Yen. A sharp drop in high-volatility or high-yield currencies can also have the same effect. The Swiss National Bank and the Swiss Financial Market Supervisory Authority (FINMA) declined to comment on the impact of arbitrage trading on the Swiss Franc. In early August, as the stock market plummeted, the Swiss Franc rose by 3.5% in just two days. The Swiss Franc to US Dollar exchange rate is highly sensitive to the US economy and tends to rise significantly when US economic data weakens (leading to a decline in US Treasury yields). "Any arbitrage trading carries inherent risks, especially for those trades using safe-haven currencies for financing," said Michael Puempel, a foreign exchange strategist at Deutsche Bank. "The main risk is that when yields decline in a risk-off environment, spreads compress, and the Swiss Franc may rebound," Puempel added. A measure of investors' expectations of Swiss Franc volatility derived from option prices is currently at its highest level since March 2023. Nathan Vurgest, trading director at Record Currency Management, stated: "Considering the central banks, you can see that some arbitrage players may prefer the Swiss Franc over the Japanese Yen. The success of such arbitrage trading may still depend on how quickly traders can liquidate in a risk-off sentiment."