How have expectations of monetary policy change impacted hedging costs?


Following last week’s FOMC meeting, the committee elected to keep the Fed funds target rate unchanged at 1-1.25%. The outcome was widely expected and hence there was no significant change in the markets. The accompanying statement included a number of small changes which have firmed up expectations that we can expect an announcement with regards to balance sheet normalisation at the next meeting in September, but once again, this was broadly expected and hence had little impact on markets.

 

Taking a step back from intraday market movements, the bigger picture tells a more significant story – namely that central banks are starting to tighten their ultra-loose stance on monetary policy. Most importantly, it’s not just the Fed either, the Bank of Canada raised rates earlier this month (and are expected to do so again before the end of the year) while the Bank of England and even the European Central Bank are also making noises about tighter policy.

 

As a result, we are starting to see changes in interest rate differentials which are impacting market conditions for those hedging FX exposures. For example, a USD fund investing in a EUR asset, was benefiting from a 275 basis point pick-up (on an annualised basis) back in December 2017 (see chart below). At that time, the Federal Reserve had just raised interest rates and there appeared little prospect of the ECB tightening in the foreseeable future. 

 

Picture1

 

Seven months on, that pick-up has narrowed to 216 annualised basis points amid speculation that the Fed’s ability to continue raising rates at the same pace is diminishing while the prospect of the ECB tightening is no longer unimaginable.

 

A similar scenario exists for a EUR fund hedging a GBP asset. Back in December 2016, a EUR denominated fund was incurring a 121 annualised basis point ‘cost’ when hedging GBP assets using a 5 year forward (blue line on chart below). That has since narrowed to 84 basis points (annualised) on the assumption that the differential between the EUR and GBP curves will start to shrink.    

 

Picture2

 

In recent years, many EUR denominated funds have tended to use short dated, rolling hedges to benefit from a narrower differential and also avoid having to lock in a cost. While the latter still rings true, when the cost is annualised, a longer dated hedge is now marginally cheaper than a shorter dated, rolling strategy. Therefore, where a fund is solely focused on minimising cost, a short dated, rolling strategy may no longer be cheapest. It should be noted, that this analysis doesn’t make any allowances for credit charges and roll costs (both of which will be client/counterparty dependent) which will have an impact upon pricing.

 

In conclusion, the changing outlook for global interest rates is resulting in a notable change for the impact of hedging programs on returns. This is a perfect example of why hedging strategies shouldn’t remain static and instead warrant a more dynamic approach that is reviewed regularly. In our view, the central banks are likely to find it very difficult to dramatically tighten policy, but as market perception differs, we are likely to see increased volatility in this space. 

 

As always, please don’t hesitate to speak to your consultant who will be happy to provide data for other currency pairs and tenors and discuss more specific situations, objectives and constraints.   

 

 

Author: Marc Cogliatti



 

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