A very binary world

A very binary world

Moritz Sterzinger Weekly bulletin October 2018
Much of the financial world appears to be gripped by fears of an imminent global recession. It is a hot topic at conferences, where economic pundits seem to talk about little else and recently, the Economist ran a piece looking at what the next downturn might look like. In fact, it appears that not thinking there will be a recession within the next 12 to 15 months is quite a contrarian stance.

Should you worry about a recession? It is obvious why you might: the potential for Italy to blow up the Eurozone, a hard landing for China, Brexit, Fed tightening, geopolitical risk, Trump’s trade policies – the list goes on. Nevertheless, these are exactly the same concerns that kept investors awake at night for the last two years, and yet the world has refused to fall apart. The US economy continues to defy expectations, with Q3 GDP growth coming in last Friday at 3.5%, 0.2% above expectations. And for those worried about the Fed tightening too aggressively, leveraged loan default rates continue to run below 2% (trending down) with interest cover standing at a high of 4.4x.

Of much greater concern is the binary nature of the paths interest rates and currencies will follow depending on whether the recovery persists.

Consider interest rates. USD swap rates for tenors longer than two years are now running above 3%, with short-term rates converging towards that mark. While still far below USD rates, EUR and GBP swap rates have also risen from their lows. Should an economic slump now materialise, there is (finally) room for rates to move lower.

The potential regret from locking in a rate that in hindsight turns out to be much higher than the realised trajectory shouldn’t be ignored. On the other hand, if the recovery continues, current interest rate expectations may well be on the low side. Hence it is difficult to judge whether current swap rates represent a good opportunity, or a potential cause of “hedger’s remorse” further down the line.

Similar considerations apply to currency markets. GBPEUR has been range-bound between 1.10 and 1.15 for more than a year now. Where would it trade in the event of a chaotic no-deal Brexit – at parity? Maybe even lower? And where would it go if Downing Street and the EU reached an agreement that gets through Parliament? 1.25? Back to 1.30?

Whatever the outcome, it is hard to imagine GBPEUR staying at current levels for much longer. There will be a move at some point soon and it will be anything but small. It is easy to make the case for hedging any GBPEUR exposure given these odds. It is less clear whether you’d be content with just fixing your GBPEUR rate when you may stand to win big if it moves in your favour. Needless to say, GBPUSD and EURUSD appear equally ripe for sudden, significant swings.

Whatever the market, in the context of hedging it is advisable to build in flexibility in order to take advantage of large, favourable moves. As uncertainty and event risk have grown, so have premiums for protection. Yet with the risk landscape looking increasingly like a series of coin tosses, it seems worth paying up.

Upcoming data releases

It is a reasonably busy week on the data front with Eurozone GDP data for the third quarter coming out on Thursday (expected to be 0.4% as the previous quarter). In the UK, all eyes will be on the BoE – less so because of its interest rate decision (it is expected to keep rates at 0.75%), but rather because of the accompanying inflation data and commentary by Governor Mark Carney.

Last but not least, US employment data on Friday is expected to signal a rebound in Non-Farm Payrolls (193k vs. 134k the previous month) with the unemployment rate staying at record levels of 3.7%. With unemployment so low, participation rate and wage growth will become more important in gauging the US economy’s trajectory.

For more information, please contact Moritz Sterzinger, Associate Director at JCRA, at Moritz.Sterzinger@jcrauk.com.

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