Wednesday 19 saw a seismic shift in the FOMC ‘dot plot’ with nearly half of Fed participants now judging that rate cuts will be appropriate this year. The market reaction has been, understandably, dollar negative and the greenback is now trading down against all but one of the major currencies over the past month.
For the euro, this has meant a rally from around 1.1185 last week to breaking through 1.14, for the first time since mid-March. Similarly, against the pound, the euro is up over 4% since the lows in early May as the resignation of the PM raised chances of a ‘no deal’ Brexit and subsequent sterling weakness.
EUR/USD – Trades above 1.14 for first time since March
EUR/GBP – 4% gain in the past two months
Looking ahead at central bank policy
Markets are now forecasting a greater than 50% chance that the Fed will initiate at least four 25bps rate cuts in the next 12 months, taking the base rate back down to 1.25-1.50%. Similarly, it is expected that the ECB will also look towards monetary easing in an attempt to boost growth. However, with a base rate at -0.40% the ECB have comparatively far weaker firepower than the Fed who are nearing the end of a three-year, 225 basis-point, hiking cycle.
We have already seen this starting to impact FX markets and in the past two months a 20 basis-point drop in yield spread between 10-year treasuries and bunds has coincided with ~2.4% gain in EUR/USD. If the Fed further revise down the ‘dot plot’ and begin cutting rates aggressively, then we could see the EUR/USD rally progress into 2020.
Back-testing Fed rate cut cycles
Indeed, looking historically, when the Fed embark on rate-cutting cycles we see that EUR/USD tends to rally strongly. In the graph below you’ll see that when the Fed began easing from 2001-2003 EUR/USD rallied ~35%, and then once again when the Fed began easing in September 2007 EUR/USD rallied ~15% in the following 10-months.
Given the market expectations for continued EUR strength we are seeing managers question whether now is the time to re-evaluate hedging and predominantly we see three main strategies.
1) Rolling FX swaps
Probably the most common strategy we see is that of short dated (1-month to 1-year) rolling FX swaps. Shorter dated swaps are relatively capital light with highly liquid interbank markets allowing clients to reduce trading costs.
The downside of this strategy is that at each maturity, if the hedge has gone against a client, most providers will ask for this to be cash settled when the new hedge is placed. We have tweaked our offering so that clients can embed a negative cash settlement into the new hedge, therefore avoiding the need to hold excess cash or having to call commitments from LPs.
2) Long dated hedging
We are seeing some funds look to lock in longer dated hedges (2 to 5 years) to match the hedge settlement with the expected maturity of the underlying investment. This is more capital intensive than the rolling swaps strategy but gives funds the certainty that they have a hedge in place for the expected duration of their portfolio investment.
Some fund managers we speak to are cautious of longer dated hedging as they do not know the exact exit date for their investments, in these instances we can offer to reduce or extend the FX hedge maturity as required as we approach the maturity date.
3) Deferred Premium option
Option strategies can often look attractive as they provide guaranteed downside protection while still allowing participation should rates move in your favour. However, options typically come with an upfront premium that the fund has to pay which can often look expensive and can require calling commitments from LPs.
To avoid this, we often look to defer the premium until the settlement date which allowing funds to optimise capital more efficiently.