Are currency hedged solutions the answer to market volatility?

Townsend Lansing, head of short/leveraged and FX platforms at ETF Securities, explains how currency hedging in the ETP space can be used to exploit market dislocations

Financial markets have all been strongly impacted by the actions of key monetary authorities since 2008, with the foreign exchange market particularly feeling the effects.

Currency volatility has trended upwards in the past year and looks set to remain elevated (see chart). Diverging monetary policy, volatile commodity prices and the economic future of China are all uncertain factors that will keep currency markets from stabilising in the near future.

The Federal Reserve has adopted a data-dependent approach in determining the timing of its first interest rate hike, exacerbating market reactions to any indicative data releases.

Prior to September, the futures market priced in an approximate 50% chance that the Fed would use its September meeting to initiate its tightening cycle, however dynamics quickly shifted on 11 August as, in a shock move, Chinese authorities allowed the yuan to devalue against the US dollar.

What followed was a period of equity market capitulation and dollar weakness as rate hike.

“The turbulent landscape also presents opportunities for investors to implement tactical short and medium-term currency views and exploit temporary market dislocations.

expectations shifted. The situation served as a stark reminder that the data dependent approach of the Fed gives them considerable flexibility to respond to market challenges, which, for the foreseeable future, will keep markets guessing and exchange rates shifting.

Exchange rate fluctuations

With currency market volatility surging, the decision of whether to hedge incidental currency exposure has moved front and centre for many international portfolio managers, who have seen the risk/return profiles of foreign assets distorted by exchange rate fluctuations.

In the exchange-traded product (ETP) space, the growth in demand for currency hedged ETPs has highlighted the challenges that asset managers are currently facing.

Currency hedged ETPs offer a means of gaining exposure to foreign assets while neutralising the impact of oscillations in the relevant exchange rate.

As the currency hedge is embedded in the underlying benchmark, these ETPs eliminate the need to implement a direct currency hedge; a task that requires considerable expertise and operational capacity.

Their cost-efficient and convenient nature has caused these products to grow in favour with international managers, particularly in the last 18 months, where currency volatility has climbed as a result of active monetary policy measures.

In Europe alone, currency-hedged commodity ETPs have witnessed $224m of inflows as investors have sought protection against moves in the euro/dollar exchange rate, a currency pairing whose recent fluctuations effectively characterise the current state of the foreign exchange market.

implied-fx-volatility-index-1-compressed

Rate pressure

The turbulent landscape also presents opportunities for investors to implement tactical short and medium-term currency views and exploit temporary market dislocations.

Currently, the dollar is in the midst of a moderate retracement against its major developed market counterparts as a result of a below expectation payroll reading for September.

The data stoked fears that the US labour market may be vulnerable to weakness from abroad and reduced the probability of a 2015 rate hike. Fundamentally, many still believe the US recovery has legs, and anticipate the Fed to raise rates in December or the first quarter of 2016.

This will sit in contrast to the monetary situation in Europe and Japan, and should eventually support a continuation of the dollar rally against the euro and yen that we saw earlier this year.

However, in the coming months, if key economic data releases fail to reassure investors of the US growth story, we could see the dollar remain under pressure.

For those emerging markets ladled with US dollar-denominated debt, the impact of the imminent rate hike has been two fold.

Emerging markets

The other prevalent theme in FX markets is the sustained weakness of commodity and emerging market currencies against the dollar.

Key commodity currencies such as the Australian, Canadian and New Zealand dollar have suffered (falling on average by 15% in 2015) as the price of their commodity exports have plunged.

This trend may continue against the greenback, as the impact of price declines continues to filter its way through to respective business sectors and domestic labour markets.

This feedback loop will likely see respective central banks in these nations remain accommodative, while the US moves ever closer to its landmark rate hike.

For those emerging markets ladled with US dollar-denominated debt, the impact of the imminent rate hike has been two fold.

Firstly, the prospect of higher rates has prompted capital flows back into the US; and secondly, a stronger dollar has increased the value of liabilities for local corporations. As the rate hike approaches, these factors should corroborate to keep the dollar supported against emerging currencies.

Source: Investment Week

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