Unsurprisingly, the outlook for US interest rates has been hot topic this year. In last week’s report, we highlighted that market expectations have shifted dramatically in recent months with the majority of economists now expecting multiple rate cuts before the end of 2019 (compared to a strong bias for further tightening at the start of the year).
With this in mind, all eyes and ears were on last week’s Fed meeting for further insight into the committee’s thinking about monetary policy going forward. According to the markets, there was an outside chance of a cut, but none of the 43 economists polled by Bloomberg were expecting a change this month. In the end, the committee voted to keep policy unchanged although communicated a clearly dovish intent in the accompanying statement. According to the latest dot plot, eight participants forecast a rate cut in the months ahead, seven of which forecast 50 bps worth of cuts by year end.
As John mentioned last week, we think all the talk of aggressive rate cuts this year is a little over hyped. Recent economic data has hardly been supportive of looser policy and while there is understandably plenty of concern about the impact of trade wars, lower rates are unlikely to alleviate these worries.
That said, the market is what it is, and as such, it makes sense to review what impact this has on hedging strategies. Funds denominated in US dollars have been enjoying an ever increasing ‘pick-up’ from hedging euro and sterling exposures in recent years.
The charts below show the annaulised impact (in basis points) for a US denominated fund hedging EUR and GBP exposures using forward contracts. Over the past twenty years the impact has fluctuated wildly, but having resulted in a substantial ‘pick-up’ in recent years, narrowing interest rate differentials mean this is fast changing (note the move over the last 12 months circled in red).
Expectations of lower rates are also evident when looking at US swap rates. Funds are now able to swap floating rates for fixed rates beneath 2% for the first time since September 2017. Unsurprisingly, a number of clients have been in touch enquiring about how best to take advantage of the drop in funding costs.
If the Fed fails to deliver on the expected rate cuts, we would likely see the differential widen again and the FX hedging ‘pick-up’ for US investor increase (assuming of course that GBP and EUR rate expectations remain unchanged).
Looking ahead, the next Fed meeting is scheduled for 31st July. The market is pricing in a 25bps cut as a certainty and puts the probability of a 50bps cut at 34%. In terms of data, the final estimate for Q1 GDP figures are published on Thursday this week and the GDP price index is published on Friday. A weaker than expected reading for either could sway the Fed towards the more aggressive cut although for now, our expectation is that Powell and Co will settle for 25 bps to begin with.