For the first time since the 2007-08 financial crisis we are seeing the emergence of synchronised global growth in the major economies and the start of a restorative process by the US Federal Reserve, and other central banks, of more normal monetary policy settings. Since September 2017 the expected yield-to-maturity on US$ overnight cash, over a three-year period, has risen 115bp from 1.35% to 2.50%. Broadly speaking, over the same period other G10 countries have had relatively stable expectations for benchmark cash rates.
Expectations of economic outperformance in North America have driven US swap rates higher relative to most other developed economies. This is having a big impact on forward currency and funding markets and upending traditional relationships, especially at the long-end of the yield curve between the G10 currency pairs.
For example, Australian fund managers are accustomed to receiving a "carry" (financial impact of hedging forward in the currency markets) benefit when protecting the translated value of US$ assets and distributions back to A$. This has now flipped to being a carry cost due to the movement of swap rates in the US and Australia.
Conversely, in many currency pairs, US$-based fund managers are now enjoying a historically high carry benefit when they hedge G10 currency exposures back to US$. The one exception is the Japanese yen. For Euro asset portfolios, hedging the net asset value of investment back to US$ is resulting in the most favourable carry benefit since the Euro’s inception. For example, the five-year forwards now represent a carry benefit approaching 3% per annum.
Rethinking hedging strategies
These movements in the forward interest rate markets are changing the way that clients think about hedging, which currencies they hedge and the tenor. Australian fund managers continue to buy offshore assets but are adapting a more dynamic approach to hedging strategy and tenor based on different currency pairs. In contrast, US$-based managers are looking to extend hedge tenor, and even use some of the carry benefit to add more flexibility in hedging structures via the purchase of FX options, particularly for Euro exposures.
Nowhere is this theme more evident than for alternative asset managers who invest in infrastructure and real estate assets. Globally there is increasing interest in building and investing in infrastructure. Against the backdrop of an ageing population, alternative asset managers and pension funds have become the logical buyers of infrastructure given their stable, long-dated cash flows. This dynamic of more stable returns and increased competition for assets typically results in a lower Internal Rate of Return on infrastructure assets, meaning currency movements can often have considerable impact on managers’ returns if left unhedged. How managers handle this currency risk can vary depending on their mandate and investors’ tolerance for volatility in the functional currency return.
With financial markets continuing to factor in higher US$ rates and stronger global growth there is increasing risk that this will not eventuate as planned. If rates rise in the rest of the developed world, or the US rate outlook moderates, it is likely these historic interest rate differentials retract.
Our conversations with US$-based fund managers have involved investigating hedge duration when modelling potential acquisitions or hedge strategies. Extending the overall duration of hedging to crystallise these improvements may be warranted.
Equally for non US$-denominated managers, ensuring that the carry cost is considered when exploring hedge strategy and duration is prudent. A more dynamic strategy may reduce carry cost associated with the hedge portfolio.