Hedging is one way for investors in the dollar to reduce the risk presented by the currency’s unpredictable movements
• Political risks have played a large role in pushing the dollar down against the euro since the start of 2017
• The winding up of quantitative easing could lead to higher volatility
• There are a variety of ways in which pension funds can respond to movements of the dollar
• The right course of action for pension funds depends on how much risk they are prepared to take
One asset management research head recently complained that it had become impossible to predict the short-term direction of the dollar: “It moves every time Trump opens his mouth. And what comes out of his mouth depends entirely on which adviser he spoke to last.”
If one had access to the commander-in-chief’s diary, one could possibly make significant gains trading the dollar on the basis of foreknowledge of his meeting schedule. Without that, European investors holding US assets are in the uncomfortable position of navigating both short-term volatility, and uncertainty over the longer-term direction of the dollar.
The dollar has been weakening against the euro since the start of 2017. “Back at the start of 2017, the euro was certainly undervalued,” says James Wood-Collins, CEO of Record Currency Management: “The valuation gap has narrowed but not disappeared.”
Bernhard Eschweiler, senior economist at currency strategists Qcam based in Zug in Switzerland, agrees: “Our current purchase power parity estimate for the euro/dollar is 1.29, so the euro is still undervalued but this has narrowed significantly since the start of last year.”
Political risks had a lot to do with keeping the dollar depressed last year, says Ugo Lancioni, global head of currency at Neuberger Berman. However, these have receded: “Fears of a hard Brexit in the UK and of a breakup of the EU before the election of [French President Emmanuel] Macron pushed valuations of sterling and the euro lower.”
“This year, Europe’s relative outperformance has faded, and the forces that helped Europe have balanced out,” says Eschweiler: “We expect this to last for some time until one comes to the fore, and to see a trading range of 1.22 to 1.25.” So the euro and dollar differential could stick around for some time.
This risk can be mitigated through hedging, which replaces the risk-free rate of the dollar with that of the euro through forward contracts. However, that has become an expensive business as European and US monetary policies diverge, with the US in a tightening phase, unlike the euro-zone. As US rates rise relative to European ones, so does the cost of hedging dollar risk back into the domestic currency.
“Three-month dollar to euro forwards now carry a cost of more than 300bps, a substantial drag,” says Lancioni: “Sterling-based investors are paying about 160bps. It’s worse for Swiss franc-based investors, who are faced with about 340bps of hedging cost.” While this will eventually change as policies as monetary converge, this is unlikely any time soon: “It would need significant inflation to appear in the euro-zone, forcing the ECB to raise rates, or an economic downturn in the US, which would in turn cause the Fed to drop rates.”
Wood-Collins says it is unfair to consider this spread to be a cost, arguing: “Transaction costs are low – one or two basis points over a year – as the dollar-euro is the most liquid pair in the world, and the bid-offer spread is consequently small. The interest rate differential embedded in the forward contract – priced as the spot rate adjusted for the interest rate – is significantly costlier, but there is no way to avoid this, otherwise you would create a round-trip arbitrage opportunity.”
As the risk-free rate differential between dollar and euro is now negative, he says, “it feels like a cost but it’s the nature of the transaction itself,” adding: “While it’s a factor, it hasn’t been enough of one to deter our clients from taking out this hedge.
Eschweiler agrees that while this interest rate differential has pushed up the cost for European investors, “we have not seen much of a reduction in hedging”.
So do European investors who need to hedge just have to bear the pain? There are ways that this can be mitigated, says Eschweiler, “such as using a panel of banks rather than one counterparty in order to increase competition, or using a professional overlay manager. It’s also possible to optimise by using a tenor management approach, in which one looks at the most favourable hedging tenors.” For example, depending on market conditions, changing hedging tenor from three months to one, or avoiding certain dates, such as month, quarter and year-end, when costs tend to be higher, could benefit investors.
Depending on risk budget and mandate, there are a variety of ways in which pension funds can respond to movements in the dollar and the costs of hedging.
“At one end of the spectrum, you have currency management simply as hedging currency risk, and at the other end you approach currency as an asset class, and have an active strategy to generate returns,” says Eschweiler.
While the former is costly at the moment, it has the benefit of smoothing out returns, which may be the main objective and, over the long run, things even out: “This is over time a zero-sum game,” says Wood-Collins. “The percentage of dollar assets hedged here will be constant over time.” And as interest rate differentials swing reverse – as they eventually will – so does the cost. However, for those who don’t want to take the short-term pain, “a more tactical approach is to employ a more dynamic use of forward contracts, with greater hedging when the dollar is weakening, and less when it strengthens.”
“The latter, however, entails more risk,” says Eschweiler: “Whether it is right for the individual pension fund client depends on how much risk they want to put on the table.”
That seems to be an attractive option, as he says: “We are seeing a lot more RFPs come in, and more funds who are open to active management of currencies.”
Such conversations may become more frequent, as Lancioni says: “We could be moving into a higher volatility regime as central banks exit QE, and this could work to the advantage of those actively managing FX.”
RCM says that it, too, is discussing with euro-denominated institutional investors as to how best to manage their exposure. “One client has increased their percentage hedge over the past 15 months, and that appears to have been the right thing to do,” said Wood-Collins. “The question is, is there more to come – how long do we leave it before we reduce this from 100% to 50% or 70%?”
“Our current purchase power parity estimate for the euro/dollar is 1.29, so the euro is still undervalued but this has narrowed significantly since the start of last year”
One thing Wood-Collins has noticed, is an increase in managing dollar exposure from alternatives investors – for instance, private debt and private credit – who are doing some lending in dollars and need to wholly eliminate currency risk, so will hedge 100%: “Likewise, managers who need to ensure that their dollar and euro returns track each other closely will need to hedge accordingly.” Exceptions can be those illiquid investors where capital is tied up for the long term and who take the view that currency fluctuations will net out over the period, he says.
For those worried about the cost of hedging and with the investment freedom to respond, Lancioni says: “If the cost of hedging keeps increasing, we would recommend lifting some hedges and taking more risk on the currency side. We think that while the dollar is still overvalued, it’s now much closer to fair value. By lifting some of those hedges, you have the advantage of picking up more yield when buying dollar-denominated assets.
“At this stage, investors can be more opportunistic in their approach.”