There has been some debate as to whether the coronavirus qualifies as a Black Swan event.  Black Swan events are defined by Nicholas Taleb as:

  1. The disproportionate role of high-profile, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance, and technology.
  2. The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities).
  3. The psychological biases that blind people, both individually and collectively, to uncertainty and to a rare event’s massive role in historical affairs.

Point 1 us just plain fact.

Addressing point 2, I think it’s fair to say that virtually no one anticipated that a virus stemming from a market in a city no one outside of China had ever heard of would rapidly spread around the globe, now infecting people in more than 100 countries.

For the third point, it’s clear that biases have blinded many people to the potential impact of the coronavirus, as we’ve all heard the argument that the common flu virus kills far more people annually than Covid-19 has, by a long shot.  Thus far this is holding, and yet we continue to see outsized moves in many asset classes (bonds, stocks, oil).

OK, So It’s A Black Swan. What Does This Mean For FX hedgers? 

Two key prices impact FX hedgers:  1. The spot level at the time of hedging as this is the key to the hedging of funding risk. And 2. the forward points out to the desired hedge date.   The spot rates are very transparent as they are available on many websites.  However, those prices are indicative only and during periods of high volatility, one can expect the spread from the indicated market price to widen as traders have to protect themselves from this volatility when taking on your risk. In terms of the forward point impact on investment hedging, it’s best to look at it in terms of carry.

What is carry?

Carry for hedgers is defined as the annual basis point impact experienced through mitigating FX risk via the forward market,  It is essentially a measure of the interest rate differential between the domestic and the foreign country, over the tenor of the hedge, expressed in annualized basis points.  For simplicity sake, let’s look at a USD fund hedging their investment risk using FX forwards or swaps  (EUR or GBP denominated funds can consider the analysis below in the reverse).

In times of high risks to domestic and global growth, central banks have little in their arsenal aside from manipulating short term rates to try to spur on spending by consumers and corporations.

Given that the US has had the highest interest rates across the developed markets for many years now, US funds hedging developed markets currency risk have enjoyed positive carry.  Said another way, from a pure price perspective, US dollar funds have been getting paid to hedge. As the chart below shows, up until late 2018 (left of the red horizontal line), this carry benefit had been increasing steadily, as US rates continued to increase relative to UK, Eurozone, and Canadian rates.  In EURUSD (green line) this equated to a maximum of 350 annualized basis points (abps, ignoring credit charges applied by the bank).  For GBPUSD (purple line) this was as high as 195 abps, and for CAD vs USD (blue line) this maxed out at 82 abps, albeit slightly later on. 

Chart 1 – 1 yr Carry vs USD (annualized basis points (abps))

Source: Bloomberg

Since peaking in 2018, the carry benefit has reduced significantly (right of the red line) and is quantified in Table 1 below.

Table 1: Change in Carry Benefit for USD Funds (ignoring credit charges)

This change has had a marked impact on the hedging benefit for USD funds, and in the case of those USD funds with CAD exposures, they now have to “pay” to hedge these risks.  For those with EUR or GBP exposures, while they still see a pick-up to IRR from hedging, it is significantly lower than it was in the past.  Factoring these changes into both the investment thesis and the tenor selection of hedges become important considerations.    

From a hedging perspective, with the benefit of hindsight, it is clear that maximizing hedge tenors back in 2018 and 2019 was the right way to go as USD funds would have locked in those higher levels of positive carry (e.g. hedging out to 5 years as opposed to 1 year). 

With the changes in the interest rate differential, and in particular the action by the Federal Reserve last week to cut rates by 50 bps between meetings, what should we expect for the future path of carry?

One could argue that the decision to cut rates aggressively by the Fed was spurred on by the change in market expectations.  Only two weeks ago, the markets were pricing in virtually no chance of a rate cut by the Fed for the upcoming March 18th meeting.  As the coronavirus spread outside of China, and particularly to inside US borders, market players started pricing in expectations of aggressive Fed action to address growth fears.  Only five days after expecting no change in rates, the market pricing indicated expectations of 38 bps of cuts, and then 2 business days later the Fed acquiesced by cutting 50 bps intermeeting, something they haven’t done since the financial crisis.  I have long argued that the Fed doesn’t lead the market, the market leads the Fed.

What is the market pricing in now?

As of the time of writing this, the market expectations are for the Fed to cut an additional 75 bps at the March 18th!  These are seriously aggressive market expectations, and if this plays out, would equal Fed actions undertaken in the past during serious crises (recessions, financial crisis).  The difference this time, as can be seen by chart 2, is that rates are coming off much lower levels than in past cutting cycles.

Chart 2: Fed Rate Actions (1970 – present)

What does this mean for carry?

It’s important to remember that carry is a measure of the interest rate differential between two countries.  So, while the US is expected to continue cutting rates, to forecast the future direction of carry, we need to ask ourselves; what are the UK, Eurozone, and Canada likely to do? 

The Bank of Canada also cut rates last week by 50 bps, also reacting to a market that had priced in 41bps of cuts before the meeting.  With oil experiencing its worst one-day sell-off in decades, the Bank of Canada is expected to take additional measures to try to keep inflation near its 2% target.  If this is the case, expect carry in USDCAD to remain relatively stable at current levels.  If the BoC doesn’t cut as aggressively as the Fed is expected to do, this carry will continue to become more negative.

The ECB’s refinancing rate sits at 0% currently, and Lagarde had expressed the desire to move away from negative rates, so clearly they will have to use other policy tools aside from rate cuts.  The market is only pricing in 9 bps of cuts for the March 12th meeting, and almost nothing thereafter.  Expect carry to continue to come off if this is the case.

The UK’s MPC hasn’t touched rates since hiking back in August 2018, and the rate sits at 0.75%.  They also have room to move rates lower and the market is pricing in expectations of 50 bps of cuts at their March 18th meeting.  However, beyond this next meeting there are virtually no additional cuts priced, and so if the US continues on it’s cutting path, interest rate differentials will narrow, and carry will continue to come lower, and may even move into negative territory.

The bottom line: USD funds should continue to extend hedges out to their maximum tenor as long as the threat to the US and global growth from the coronavirus continues to grow and should take action sooner rather than later on upcoming expiries, as things may continue to get worse.

Author: John Glover