The Autumn of Dangers
18 October 2022
Political Volatility meets Pivot Chatter
28 October 2022RISK INSIGHTS • 26 OCTOBER 2022
Five key takeaways from the recent politico-economic turmoil
Marc Cogliatti, Principal, Global Capital Markets
As tempting as it is to write another rambling piece about the state of UK politics and what another new prime minister might mean for sterling, I thought I’d deviate slightly and take the opportunity to recap on some important points for consideration that have arisen of late.
The past month has felt like June 2016 or March 2020 all over again. I’ve lost count of the number of ‘tail risk’ market moves over the past few years, but they are certainly becoming more frequent. Below, I’ve set out five very different reminders from the past few weeks:
- Liquidity Risk – There is always the problem of being underhedged when markets move against your underlying exposure and likewise being over hedged when markets move in your favour. However, the issue causing the biggest problem is what happens when the market moves against your hedge and your mark-to-market valuation becomes increasingly negative. Most of our clients operate with large CSA thresholds or even fully uncollateralised non-CSA lines, but even then, problems arise. Whether it’s breaching a threshold and having to post collateral, or exceeding a bank’s credit appetite and being unable to place new trades or roll existing positions, a hedge portfolio with a large negative valuation can be problematic. Hence, many of our clients have liquidity management as number one in the KPIs of their best execution policies and why we focus so heavily on it when designing and evaluating possible hedging strategies.
- Interest rates move (and can do so very quickly!) – After a decade of ultra-loose monetary policy and very little prospect of rates returning to what some might have described as ‘normal’ levels, we’ve seen a dramatic upwards shift in global rates as central banks try to bring inflation under control. Unsurprisingly, we’ve seen a big increase in both existing and prospective clients seeking our assistance managing interest rate risk (particularly portfolio companies of sponsors we are already working with). Interest rates changes are also significantly impacting FX hedging costs. Six months ago, dollar fund hedging a sterling asset five years forward benefited from a 51 annualised basis point pick up. Last week, that same hedge cost 31 basis points. Today, it cost 8 basis points, so needless to say, volatility is still a key feature. Another important point to note regarding the spike in interest rates is the increased cost of funding historical rate rollovers and novations. Costs are still comparable to what you might expect to pay on a subscription facility but using debt vs equity is no longer the no-brainer it once was.
- Don’t rely on correlations – They tend to break down just when you need them most. Conventional wisdom says that rising interest rates are typically positive for a currency, relatively speaking, of course. However, despite sterling rates rising sharply, resulting in the GBPUSD flipping from positive to negative, the pound has remained under intense pressure and trades close to historical lows.
- Prepare for the unexpected – Clients have often questioned our analysis when we’ve used simulations and calculated something to a 95% or 99% confidence level and said it’s too conservative and will never happen. Granted, the probability of such an event occurring is low, but thinking about what could happen, particularly with regards to liquidity at risk, and taking a cautious approach can help provide some comfort if/when the inevitable does happen.
- Public finances do matter! – When I started my career back in 2003, trade and current account balances were hot topic and key influences over currencies. However, since the financial crisis, markets seem to have paid surprisingly little attention to government borrowing, particularly within the G10. However, that dynamic may be starting to change, as we’re seeing in the UK, where markets are punishing sterling for a potentially unfunded rise in government spending.
One final point to remember: communication is key – this is arguably true in all walks of life, but especially so during times of uncertainty. Whether it’s regular communication with investors or hedging counterparties, everyone takes comfort in understanding what’s going on.
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