* SNB policy review could see Swiss franc weaken further
* One-month risk reversals indicate euro gains/franc weakness
* Swiss investors expected to invest offshore
By Anirban Nag
LONDON, Sept 17 In a world where prospects of stronger economic growth and higher market interest rates are driving the most active currencies, the safe-haven and low-yielding Swiss franc faces a lengthy period of weakness.
Swiss investors are again looking abroad for returns, particularly in the euro zone, confident that a recovery is gaining ground and worries about a debt default have waned.
At home, the Swiss National Bank (SNB) is likely to hold interest rates at ultra low levels for some time until it believes the threat of deflation has passed.
With the central bank probably also keeping its cap on the franc's exchange rate when it meets this week, this all adds up to a likely fall in the Swiss currency and its weakness against the euro is expected to accelerate in the next few months.
Switzerland maintained its reputation as a safe place during the turbulent years that followed the 2008 financial crisis, even though its biggest bank UBS needed a government bailout.
This created problems for the SNB. The franc rose sharply in 2010 and 2011 as investors, worried about a sovereign debt default in the euro zone, pushed the Swiss currency close to parity with the euro.
In response the SNB drew a line in the sand, setting a cap on the franc of 1.20 per euro in September 2011, aiming to protect the export-driven economy from recession and deflation.
Every time the Swiss currency neared the cap, the SNB went into the market to buy euros for francs, pushing the rate back.
Now the Swiss economy is growing robustly and inflation is absent, giving the SNB little reason to tighten policy or remove the franc cap when it reviews policy on Thursday.
With the SNB keeping interest rates near zero, the euro has already risen 2.5 percent against the franc this year while the dollar has gained 1.2 percent. But that is far less than the respective rises of 15 and 14 percent both saw against the yen, the other major safe-haven currency.
Some investors are positioning for this week's SNB meeting to prompt more weakness in the next few months.
In the options market, one-month euro/Swiss franc risk reversals, which measure the relative demand for options on a currency rising or falling, show investors have been increasingly buying protection against a fall in the franc.
The bias for euro calls, or the right to buy the common currency against the franc, has risen since the start of this month. That contrasts with euro/dollar, euro/sterling and euro/yen, which all show a distinct bias for euro weakness.
"The very low, and on some occasions even negative, nominal return on cash in Switzerland has made the local currency less attractive," said Thomas Stolper, currency analyst at Goldman Sachs. The firm expects the euro to rise to 1.25 francs in three months and 1.28 in six, up from Tuesday's 1.2370.
"We expect the SNB to maintain the minimum level for the euro/Swiss franc at 1.20 and for that rate to remain in place until the risks of deflation have subsided. At that point, we would expect the bank to switch back to using interest rates as its main policy instrument."
That seems a long way off. Swiss consumer prices were 0.1 percent lower in August than a month earlier and unchanged from a year ago. A Reuters poll last week showed economists believe the SNB will keep the lid on the franc against the euro at least until the end of 2014.
"We continue to see euro/Swiss franc trading back over the next few months to this year's highs of 1.26-1.27 as Swiss portfolio managers return to foreign markets," said Monsoor Mohiuddin, chief currency strategist at UBS.
However, Deutsche Bank currency strategist George Saravelos said Swiss investors' purchases of euro zone assets remained well below pre-crisis levels.
"It is tough timing the return of this outflow," he said, adding these investments were an estimated 140 billion francs below their 2008 peak. But combined with the normalisation in European risk premia, these flows could see the euro rise.
Saravelos estimates 100-150 billion euros sought safety in Switzerland during the euro zone debt crisis and that this has begun to unwind.
This is reflected in a steady fall in sight deposit balances with the SNB - a broad gauge of Swiss banks' excess liquidity and of how much the central bank has spent to keep the franc weak - in the past two months.
Euro zone short-term market rates have climbed despite the European Central Bank promising to keep rates low for a long time. The yield premium benchmark two-year euro zone bonds offer over Swiss debt is near January highs.
Traders said short-dated option strikes are layered around 1.2550-1.2750 francs, which could provide short term resistance.
"Once we break through, real money with its structural overweight in the Swiss franc will be forced to shift its position with little in the way till 1.30 francs," said Olivier Korber, options strategist at Societe Generale.