As we approach the end of Q2, a time when the price of currency hedging can typically spike, we have been reviewing the likely changes in the so-called ‘costs’ of currency hedging. I use the term so-called as these are not really costs, merely a differential in short term interest rates, which for some investors can be a gain and for others it will be a reduction in the yield or return of an asset.
The unusual diversion in the path of US dollar interest rates relative to the rest of the world has made dollar assets expensive to hedge for euro and sterling investors, while dollar investors have enjoyed attractive hedging costs for euro and sterling assets back to their home currency.
Today (partly due to the half year-end spike) the pick up or drop depending on which way you are hedging between euro and dollar is around 334 basis points, if one were to hedge the asset for one month’s ownership. This means that when hedged back to euros the 2.05% 10-year US Treasury yields a staggeringly low minus 129bp, while a 10-year Bund at minus 29bp yields a surprisingly high 3.05% when swapped back to dollars.
This currency basis has probably hit an intra-cycle peak, and is about to change. Firstly the half year-end spike will disappear next week, which should reduce the basis by around 35bp. More important though is the path of short term rates. There is currently an 81% implied chance of a 25bp rate cut in the US in July, and a 19% chance of a 50bp rate cut. By the end of the calendar year there are 75bp of rates cuts priced into the US yield curve and just 10bp of rates cuts priced into euro rates. All told this adds up to a potential 100bp of swing in the price of hedging between euros and dollars, should the market implied cuts occur and the half year-end spike be removed.
For investors who currency hedge that would mean dollar assets, which have been so expensive to hedge back to euros or sterling, would become more attractive. Investors need to consider the future price of currency hedging, not just the current price, which looks to be at its peak.
