In December 2016 the FOMC initiated its current hiking cycle, raising rates by 25bps. Since then, gradually but consistently, we have seen the FOMC continue to tighten interest rates. There were three hikes in 2017 and four that followed in 2018, taking the Federal Funds target range up to 2.25-2.50%.
Given the tightness in the US labour market going into 2019, it seems that this cycle has not yet reached its peak. The US labour report for January showed 2019 starting in robust fashion, with 304k jobs created and average wage growth sticking at 3.2%. As the pool of available labour evaporates, the US worker will grow in confidence and search for higher wages. The FOMC will certainly be focussing a lot of its attention on wage inflation to make sure it doesn’t lose control.
What does this mean for the US dollar? It is not often the case that the world’s reserve currency has such an attractive yield compared to others. For example, there is a 3%+ interest rate differential between the US dollar and the euro/Japanese yen. When hedging currency risk, this yield differential is reflected in the forward points. As a result, we have seen an increase in hedging activity as US dollar funds take advantage of this gain and hedge non-USD assets at fund level.
The main objective when hedging currency risk at fund level, is to prevent negative movements in currencies from impacting the performance of the fund. For example, when GBP/USD fell approximately 20% in 2016, an unhedged US dollar fund with a 20% exposure to sterling assets would have had to tolerate a 4% negative impact on the NAV. The next consideration though is the cost of hedging. When the yield differential is high, this can be significant – but depending on the direction of the exposure, it can also be a benefit. If there is a positive contribution to the fund from hedging then surely this will make the decision to hedge that much easier.
On the other hand, for a euro fund, with euro rates still in negative territory, there is a cost to hedge sterling or US dollar assets. For example, the cost to hedge a sterling asset within a euro fund is currently approximately 1.4% per annum without considering credit charges and transaction costs.
A 1.4% cost is certainly a consideration. But to make an informed decision as to whether this cost is worth paying, one has to weigh up several factors. Firstly, how considerable is the risk that you are looking to protect yourself against? FX movements can have a favourable or adverse impact on the fund, and the average volatility in GBP/EUR in a year is approximately 12%. So is 1.4% a cost worth paying to protect yourself from a potential 12% move? Arguably yes, and what also helps in the decision-making process is the ROI of holding that asset. More often than not, when there is a cost to hedge a currency, this is because the interest rate differential is a reflection of a comparably higher ROI of the sterling asset compared to the equivalent euro asset.
There are many considerations to take into account when hedging your currency risk on the fund level. The result may be not to hedge or to hedge a lower percentage, but an informed decision is far more persuasive to your investors than ignoring the risk.
Upcoming economic releases
In the UK, following on from this morning’s release of Q4 GDP, we still have inflation data and retail sales to come. Given the growing interest in the health of the high street, it is the retail sales that will steal the focus. From Europe we have Q4 GDP too, showing how the world’s largest economic area has performed. From the US, the highlight will be inflation data. The FOMC will be particularly focussed on this, to see whether the tight labour market and strong average earnings are starting to put some upward pressure on prices.
For more information, please contact Chris Towner, Director at JCRA, at firstname.lastname@example.org.