“Moves” in Hedging Cost going into Q4 2018

With summer now arguably behind us, the countdown towards the end of 2018 has begun with banks beginning to prepare to minimize their balance sheet allocations on December 31st (largely for regulatory reporting purposes); tighter dollar liquidity/supply and demand for funding into year-end is familiar phenomenon.


Hence, we would expect to see a spike in USD hedging costs (across the currency spectrum) as we enter the month of October (with 3 month forwards crossing the “turn” of the year), and we are seeing a marginal increase to norm. Across the G5 currency space, the market generally accepts a 20-30 bps premium for rolling 3m forwards in the last quarter of the year, this year’s moves show this has increased by about 40-50bps, largely due to the Fed’s hike at their September meeting. Obviously, this is a welcomed additional yield pickup for USD investors hedging non-USD assets but an added headwind that investors hedging USD assets are now becoming acutely aware of, with many attempting to manoeuvre around their roll periods.


Fed’s hawkish interest rate policy in 2018 has also meant cost in hedging has also increased as illustrated in the chart below.



US jobs data keeps FED on track


This additional spike in hedging costs is often being cited as a reason why US bonds are not in favour with foreign investors despite the attractive yields – data from fund-tracker EPFR Global showed that average weekly purchases of U.S. bonds by non-U.S. investors have dwindled by nearly a third to $9 billion so far this month, compared with more than $13 billion in 2017.


However, the lack of appetite from foreign investors is probably more to do with the fact that the US economy is still showing signs of robustness; despite a miss in the headline payroll figure on Friday, an upward revision to the prior month’s increase (with the miss mainly attributed to effects from the hurricane Florence) was enough to demonstrate that the labour market still remains solid. The unemployment rate also hit a 49 year low with average hourly earnings increasing 0.3% in September – all signs supportive of keeping inflation around the Fed’s 2% target.


Fears of rising inflation and more interest rate hikes saw the US treasuries market continue to trade under pressure with the 30-year yield rising more than 7 basis points to 3.4036%, its highest since September 2014. This pressure/sell off is no doubt deterring foreign investors from participating.


In addition, the yield curve is also steepening, with the spread between 2 and 10-year yields last at 34.6 basis points, up from 26 on Monday last week. The 10 and 30-year yield spread sits at 17 basis points also up from Monday last week, reversing signs of an invert yield curve, signalling good signs for the overall health of the economy. Certainly, these higher yields will give a better bid tone to the US dollar across the board.


Author: James Sebastian


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