Three currencies, three different interest rate regimes, a lot of uncertainty

Three currencies, three different interest rate regimes, a lot of uncertainty

Moritz Sterzinger Weekly bulletin June 2018

One of our key messages when advising clients is that we don’t base our hedging recommendations on a particular market view. This doesn’t mean that we divorce ourselves completely from what is happening in financial markets, quite the contrary. It simply means that rather than taking a directional view, we consider the realm of the possible, imagining scenarios and thinking through what these would imply for our clients’ businesses.

Our job is to understand how a particular interest rate or foreign exchange environment can seriously imperil a client’s particular business case, and to design solutions that transfer these risks to someone else, usually a bank. When approaching hedging by asking “What could go wrong?” we need to consider the implications of both rising and falling interest rate environments.

That said, and with the Fed, BoE and ECB having recently held meetings, let us do a little bit of armchair-economics and ponder the possible paths USD, GBP and EUR interest rates may take in the near and medium term.

Starting with the US, I would like to echo the notion from last week’s bulletin, that the Fed has done a reasonable job of guiding market participants and, more importantly, sticking to its hiking cycle. So far it seems the US central bank has not been too late at taking away the punchbowl, nor have its actions sparked financial carnage through overly aggressive tightening (at least, not in developed markets), resulting in a “…beautiful normalisation” to borrow the expression from PIMCO CEO and now Allianz Chief Economic Advisor, Mohamed El-Erian. The path ahead also appears pre-determined as both the LIBOR forward curve and the Fed’s dot plots suggest a steady increase of short-term rates into 2020. It is worth noting that the interbank market does not imply rates are going to rise above 3%, whereas the Fed’s median forecast stands at 3.375%. Leaving this discrepancy aside, interest rate expectations for the longer run appear well-anchored around the 3%-mark which, together with a 2%-inflation target, implies real short term interest rates of 1% as the ‘steady state’ going forward. It is noteworthy, however, that for the past 50 years real interest rates have been higher than 2% most of the time. Considering how strong the US economy continues to look with data readings remaining relatively bullish, one can imagine how inflation overshooting its target for a prolonged period may force the Fed to tighten even further than currently projected. The ‘dot’ at 4.125% on the Fed’s dot plot representing the expectations of two outliers, might turn out to be prescient.

The elephant in the room with regard to USD interest rates remains the potential impact of fiscal policy. While an infrastructure spending bill may push inflation higher, an escalating trade war could lead to a softening of economic conditions. Yet a ‘stagflationary’ scenario as a result of tariffs on imports leading to higher prices is also conceivable, and this may prompt the Fed to lean against the wind and hold firm or even raise rates further. In summary, despite the Fed’s good track record of recent guidance, the possibility of interest rates overshooting current expectations is real.

While the near-term steepness of the USD-LIBOR forward curve is perfectly understandable, I am less convinced by the GBP interest rate curve’s prediction that there may be up to three rate hikes by the BoE before end of 2020 (some economists suggest it will be even more than that). This is reflected by the 3-year swap rate which currently hovers around the 1.10% mark (with 3m LIBOR fixing at c. 0.66%), whereas as recently as a year ago it was as low as 0.41%. I wonder whether such optimism is warranted in light of Brexit. OK, I get it: unemployment is low, retail sales seem robust and the dire predictions of “Project Fear” have not (yet) materialised – although some economic data has softened. The risk of a Hard Brexit-induced recession remains very real in my estimation, in which case I don’t see the BoE sticking to their plans for long. Then again, even if I knew for sure that a Hard Brexit was going to occur, I would struggle to form a conviction for what that meant for interest rates. Assuming the pound would take another leg down akin to the sell-off which followed the referendum two years ago, higher interest rates to stabilise the currency could be just as likely a policy response as further easing. Personally, I find the GBP interest outlook the muddiest out of all the three currencies discussed here.

This brings us on to the euro. During the last press conference, Draghi guided towards QE ending a little bit later, i.e. at the end of this year, and interest rates staying on hold well into mid-2019. This should not come as a surprise in light of all the political uncertainty and economic sluggishness that still plagues the Eurozone. With the vast majority of EUR financing being subject to a minimum floating rate of 0%, it will be a while until borrowers start feeling the impact of eventual rate hikes.

Given the overall employment picture, the potential for surprise inflation and abrupt hikes to the central bank policy rate appears low. Yet, this does not mean that borrowers should be complacent about EURIBOR risk: at the end of 2011, at the peak of the euro crisis and before Draghi’s famous “whatever it takes” speech, 3m-EURIBOR significantly diverged from the central bank deposit rate and widened to a spread of as much as 1.1% (it is currently below 0.1%). Thus, while inflation risk seems relatively remote, financial risk is not. The threat of another banking crisis could push interbank rates higher, despite the ECB keeping rates low.

So there you have it: three different currencies with very different trajectories and a multitude of potential outcomes. Making educated guesses about the future, let alone predicting it, is notoriously difficult. But asking what ‘could’ happen enables one to identify risks and prepare accordingly. And prepare I would, regardless of the currency.

Upcoming data releases

This week is pretty light on data, as economic releases for GDP inflation and employment across the UK, US and Eurozone mostly relate to revised or final numbers for previously published Q1 estimates. However, it is worth paying attention to the BoE’s Chief Economist Andy Haldane, who is delivering a speech on Thursday, as he sided with the MPC’s hawks to hike rates during the last meeting. Moreover, when he gave a talk in summer last year, his comments on raising interest rates preceded the Base Rate reversal to 0.50% in November. An August rate hike by the BoE hence looks increasingly likely.


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