New thinking on currency hedging required

  • As interest rate differentials converge towards parity, notably against the US, there are implications for the Australian investor hedging their offshore exposure.
  • The bountiful hedge “carry” that could be relied on will no longer be available forcing investors to reconsider their approach to currency hedging.
  • It’s time to work the hedging programme harder, including aggressive cost control, elevating risk management, superior instrument selection, and a more strategic approach to the hedge ratio.

It all starts with bond markets and their outlook

The Australian 10 year yield has recently come within a whisker of its US 10 year counterpart – the closest margin since they briefly equalised back in 2000.

This marks a pivotal point in Australia’s bond market history, and follows a long journey from the 200+ basis point premium that Australian bonds captured during the years of Australia’s terms of trade boom.   At a time when global cash rates and bond yields were falling sharply, the temptation of such high yielding bonds from a AAA sovereign, a dramatically dwindling group, was clear to see.  Foreign ownership of Australia’s sovereign bond purchases rose sharply over this period, to a peak of almost 80% of all ownership in 2012.


Source: QIC, Bloomberg. Forecast results are predictions only and may be affected by inaccurate assumptions and/or by known or unknown risks and uncertainties.  Forecast results may differ materially from results ultimately achieved.

From late 2011 Australia’s economic fortunes deteriorated and the Reserve Bank of Australia (RBA) joined in the cash rate cutting trend.  The spread of Australian bonds to global peers began to shrink and foreign buyers became a less dominant force in our market.

Source: AOFM

Our cash rate views call for an inversion of 10 year rates

The narrowing spread differential with the US has been consistent with the co-movement of cash rates between the RBA and US Federal Reserve (the Fed).  While there are multiple additional factors that can influence longer-tenor spreads over the short-run, it is cash rate differentials, both current and expected, that ultimately prove to be the most important longer-term influence.   

Our baseline forecasts project an inversion of cash rates between Australia and the US to occur from around mid-2018, as the Fed continues on a gradual normalisation path, while the RBA is restrained by a more sober domestic backdrop and elevated household debt metrics, which will increase the transmission mechanism and sensitivity of the economy to future rate hikes. Based on historical relationships, our cash rate forecasts imply that the 10 year spread differential could trade into mildly negative territory at some point over the next 12 months, more so than the spread environment of the late 1990s.    

The implications for domestic currency hedging programmes

This is a clear departure from the environment that dominated the last fifteen years, where investors could rely on a strong positive interest rate ‘carry’ in their hedging programme.

The level of the Australian dollar is similar to that at the end of 2003, albeit with a huge round trip from just above 0.60 through to 1.10. However, when adding the impact of carry, the cumulative return of the AUD against the USD over that period is approximately 43%.

forward returns and spot

Naturally the carry benefit would tend to bias hedge ratios higher as investors dialled down the weight of foreign currencies in the portfolio. Going forward without this inherent return benefit, the emphasis of the role of currency in the portfolio should be re-examined. Firstly, acknowledging the role of foreign currencies as a diversifier, particularly against the international equity component of a diversified/balanced fund. While we know lunches are not free, the prospect of reducing overall portfolio volatility without sacrificing return appears to be a favourable prospect.

annual aud usd interest rate carry

Moreover, as the low return investment environment is compelling investors to look more closely at all aspects of their investment process, with the carry benefit reducing, we believe its opportune to drive currency hedging programmes harder. The era of high carry and strong investment returns relegating the importance of currency management is ending. 

Ensuring quality execution is achieved is imperative to a successful and efficient currency hedging programme. However it is wise to also focus on other hedging features such as instrument selection and an intelligent approach to adapting the hedge ratio throughout the cycle to profit from currency misvaluation.

QIC’s specialists are available to have a conversation with investors to see how the changing interest rate environment affects them, and how the traditional approach to currency hedging can be adapted to changing market conditions.

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