Are the high costs of hedging for euro investors coming to a turning point?
As far as hedging decisions are concerned, the last few months haven’t been particularly easy for euro investors. Implied hedging costs for a currency are defined (partially or totally, depending on the instrument and market conditions) by the carry, (the differential between the base currency’s and the investment currency’s interest rate levels). The fact that interest rates in the Eurozone have been below zero since 2014 and decreasing ever since has created a big interest rate differential against many other countries, which explains the rising costs for the euro investor to hedge other currencies.
The one currency pair that has received a lot of attention recently is EURUSD. Costs of hedging USD for the EUR investors using FX forwards is currently 2% per annum. Very different reality if compared with early 2014, when the cost was virtually zero, or 2008, when instead of incurring a cost the euro investor would get paid around 1.9% per year to hedge the US dollar (see graph below).
As shown above, EURUSD interest rate differentials are at a historical high. The other two moments in history when we saw interest rate differentials become so wide were in 1999 and 2006. Firstly, in 1999 at the time the ECB began to set Eurozone interest rates, the US was going through an economic boom with rates at 5%. Secondly in 2006, Fed interest rates were back to 5% after 17 consecutive hikes initiated by Alan Greenspan and Ben Bernanke to control inflation. On both these occasions, Eurozone rates were around 2%.
Up until last week, it looked like the costs for the euro investor could only go up from here, both in the short and medium term. With the Fed expected to raise rates four times this year and the ECB showing no signs of monetary policy tightening, the risks pointed to an even wider carry by next year. Last Thursday, however, Mario Draghi finally indicated the ECB’s ultra loose monetary policy may be coming to an end, after recognising the risk of deflation is no longer on the horizon, giving the markets a flavour of optimism after many dovish conferences in a row. Markets immediately re-priced the chances of a rate hike by the ECB before August 2018 to 68%, from 31% previously.
On the US side, the Fed is still expected to continually raise rates this year, however, as discussed last week (link here), we are beginning to see a flattening of the US yield curve (short term rates rising disproportionately more than long term rates), which makes us question the extent to which the Fed will be able to move long-term rates up.
Combining a potentially tighter ECB policy with a restricted US interest rate curve means the euro investors may be closer than expected to receiving good news on the hedging costs front. Let’s not forget, however, that this is a (almost) zero-sum game, and good news for the Europeans means bad news for the Americans. The latter, by the way, are enjoying the privilege of getting paid around 2% a year to hedge the euro right now.
As risk managers, it is our job to reinforce the many risks surrounding this scenario, especially considering the political instability in Europe which may turn things around completely. That aside, however, we may finally say that the turning point could be slowly coming our way.
Author: Marilia Shewchenko