Risk Insight. Are the high costs of hedging for euro investors coming to a turning point? What are the chances... Volume 9, Issue th March 2017

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1 Inside this issue Big Picture GBPUSD... 3 GBPEUR... 4 Risk Insight Volume 9, Issue th March 2017 Are the high costs of hedging for euro investors coming to a turning point? As far as hedging decisions are concerned, the last few months haven t been particularly easy for euro investors. Implied hedging costs for a currency are defined (partially or totally, depending on the instrument and market conditions) by the carry, (the differential between the base currency s and the investment currency s interest rate levels). The fact that interest rates in the Eurozone have been below zero since 2014 and decreasing ever since has created a big interest rate differential against many other countries, which explains the rising costs for the euro investor to hedge other currencies. EURUSD... 5 USDCAD... 6 Economic Data and Market Indicators... 7 Appendix... 8 What are the chances.....that the Fed will hike rates this week? 100.0%..that GBPUSD will touch 1.40 in the next 12 months? 20.8% The one currency pair that has received a lot of attention recently is EURUSD. Costs of hedging USD for the EUR investors using FX forwards is currently 2% per annum. Very different reality if compared with early 2014, when the cost was virtually zero, or 2008, when instead of incurring a cost the euro investor would get paid around 1.9% per year to hedge the US dollar (see graph below)...that EURUSD will be below 0.90 at the end of Q4? 3.9% We are happy to announce that out of 80 contributors (including all major banks), Validus Risk Management has been the most accurate forecaster for GBPUSD and third-most accurate forecaster for GBPEUR in 2016, according to Bloomberg rankings. Validus Risk Management Ltd (FRN: is authorised and regulated by the FCA) +44 (0) info@validusrm.com

2 As shown above, EURUSD interest rate differentials are at a historical high. The other two moments in history when we saw interest rate differentials become so wide were in 1999 and Firstly, in 1999 at the time the ECB began to set Eurozone interest rates, the US was going through an economic boom with rates at 5%. Secondly in 2006, Fed interest rates were back to 5% after 17 consecutive hikes initiated by Alan Greenspan and Ben Bernanke to control inflation. On both these occasions, Eurozone rates were around 2%. Up until last week, it looked like the costs for the euro investor could only go up from here, both in the short and medium term. With the Fed expected to raise rates four times this year and the ECB showing no signs of monetary policy tightening, the risks pointed to an even wider carry by next year. Last Thursday, however, Mario Draghi finally indicated the ECB s ultra loose monetary policy may be coming to an end, after recognising the risk of deflation is no longer on the horizon, giving the markets a flavour of optimism after many dovish conferences in a row. Markets immediately re-priced the chances of a rate hike by the ECB before August 2018 to 68%, from 31% previously. On the US side, the Fed is still expected to continually raise rates this year, however, as discussed last week (link here), we are beginning to see a flattening of the US yield curve (short term rates rising disproportionately more than long term rates), which makes us question the extent to which the Fed will be able to move long-term rates up. Combining a potentially tighter ECB policy with a restricted US interest rate curve means the euro investors may be closer than expected to receiving good news on the hedging costs front. Let s not forget, however, that this is a (almost) zero-sum game, and good news for the Europeans means bad news for the Americans. The latter, by the way, are enjoying the privilege of getting paid around 2% a year to hedge the euro right now. Author: Marilia Shewchenko

3 GBPUSD Sterling fell lower last week as political factors take centre stage in the UK once again. Much of the focus is on the UK Brexit Bill which came up against a block in the House of Lords last week, once allowed to pass, the government could trigger Article 50 as early as tomorrow. Furthermore, the Scottish referendum has reached headlines once again and is viewed almost as an inevitability. In the US, expectations for the Federal Reserve raising rates this week are now at their highest following the excellent jobs report on Friday. The futures market is now pricing in a 100% chance of a hike on Wednesday. Key events for this week are: Mar 15: FOMC Rate Decision Mar 16: BOE Official Bank Rate Horizon Primary Indicator Score Short-Term Momentum Extremely Bearish Mid-Term Carry Bearish Long-Term PPP Valuation Extremely Bullish Support Resistance Technical View 1 GBPUSD continued its descent lower over the last week, in line with the previous week s trend and, despite having previously found some support at , the pair only haltered at around on Friday. 2 Over the last few months, the pair has consolidated between and and as such we will need to see a clear break below 1.20 in order to justify further downside risk. 3 Conversely, in order for a more bullish outlook, the pair needs to hurdle the recent high at Level 1 Level 2 Level 1 Level FX Forecasts PPP Valuation Validus Bloomberg Poll Avg Q (revised ) 1.22 Q (revised ) 1.21 Q (revised ) 1.22 Q (revised ) 1.23 Hedging Cost* Tenor Today 1M Ago 12M Low 12M Avg 12M High 6M Y Y Y (*Annualised Basis Point impact to sell GBP Forward) According to Purchasing Power Parity, GBPUSD is currently 17.3% undervalued. 3

4 GBPEUR Sterling fell lower last week as political factors take centre stage in the UK once again. Much of the focus is on the UK Brexit Bill, once allowed to pass, the government could trigger Article 50 as early as tomorrow. The ECB left rates and QE unchanged on Thursday, in line with expectations. But the factor that moved the markets was the accompanying statement from Draghi, who took on a marginally more hawkish tone than recently and stated that the ECB no longer has a sense of urgency to raise inflation in the Eurozone. Furthermore, the Euro got an additional boost on Friday on the back of reports that the ECB is considering hiking rates before QE is complete in Key events for this week are: Mar 15: Netherlands Election Mar 16: BOE Official Bank Rate Mar 16: Eurozone CPI Horizon Primary Indicator Score Short-Term Momentum Extremely Bearish Mid-Term Carry Bullish Long-Term PPP Valuation Bullish Technical View 1 After recently edging towards the top-end of the current range at 1.20, GBPEUR has fallen back toward January s lows. 2 For now, risks back towards October and November s lows around 1.10 will only open up if a break below 1.13 can be sustained. 3 Conversely, as previously highlighted, for now, any rallies towards 1.20 should be seen as a good opportunity for selling GBP. Support Resistance Level 1 Level 2 Level 1 Level FX Forecasts PPP Valuation Validus Bloomberg Poll Avg Q (revised ) 1.16 Q (revised ) 1.16 Q (revised ) 1.16 Q (revised ) 1.16 Hedging Cost* Tenor Today 1M Ago 12M Low 12M Avg 12M High 6M Y Y Y (*Annualised Basis Point impact to sell GBP Forward) According to Purchasing Power Parity, GBPEUR is currently 5.11% undervalued. 4

5 EURUSD The ECB left rates and QE unchanged on Thursday, in line with expectations. But the factor that moved the markets was the accompanying statement from Draghi, who took on a marginally more hawkish tone than recently and stated that the ECB no longer has a sense of urgency to raise inflation in the Eurozone. Furthermore, the Euro got an additional boost on Friday on the back of reports that the ECB is considering hiking rates before QE is complete in In the US, expectations for the Federal Reserve raising rates this week are now at their highest following the excellent jobs report on Friday. The futures market is now pricing in a 100% chance of a hike on Wednesday. Key events for this week are: Mar 15: FOMC Rate Decision Mar 15: Netherlands Election Mar 16: Eurozone CPI Horizon Primary Indicator Score Short-Term Momentum Bearish Mid-Term Carry Extremely Bearish Long-Term PPP Valuation Bullish Support Resistance Technical View 1 EURUSD was relatively unchanged over the last week as the support level of once again held strong. 2 Over the last 12 months the pair has formed a strong consolidation between and , aside from a brief dip lower at the end of But throughout 2017 so far, EURUSD has remained consistently towards the bottom end of this trend, indicating the increased risks to a break below Regular readers will be all too aware of our bearish forecast and for now, there is little here to alter this view. Level 1 Level 2 Level 1 Level FX Forecasts PPP Valuation Validus Bloomberg Poll Avg Q (revised ) 1.04 Q (revised ) 1.03 Q (revised ) 1.04 Q (revised ) 1.05 Hedging Cost* Tenor Today 1M Ago 12M Low 12M Avg 12M High 6M Y Y Y (*Annualised Basis Point impact to sell EUR Forward) According to Purchasing Power Parity, EURUSD is currently 13.75% undervalued. 5

6 USDCAD Friday s employment data was stronger than expected in both Canada and the US. In Canada, the unemployment rate dropped to 6.6%, the lowest reading in two years. More positive was that of the net 15,300 new jobs created in February, 105,000 full time jobs were created while part-time employment declined by 90,000. This is very positive for the economic outlook. As we mentioned in last week s report, USDCAD has been in overbought territory, and the move lower on Friday is the first step in rectifying this situation. Key events for this/next week are: Mar 15: FOMC Rate Decision Mar 24: Canadian CPI Horizon Primary Indicator Score Short-Term Momentum Extremely Bullish Mid-Term Carry Neutral Long-Term PPP Valuation Bearish Technical View 1 The rally to the mid-1.35 level resulted in an overbought situation, which will need to be unwound. 2 The next strong resistance level on the topside remains the double top at We are in the process of completing a five wave move higher, which will likely peter out towards the , in the near term. Support Resistance Level 1 Level 2 Level 1 Level FX Forecasts PPP Valuation Validus Bloomberg Poll Avg Q (revised ) 1.34 Q (revised ) 1.35 Q (revised ) 1.36 Q (revised ) 1.36 Hedging Cost* Tenor Today 1M Ago 12M Low 12M Avg 12M High 6M Y Y Y (*Annualised Basis Point impact to sell CAD Forward) According to Purchasing Power Parity, USDCAD is currently 10.58% overvalued. 6

7 Economic Data & Market Indicators Economic Matrix GDP CPI Unemployment Industrial Production Retail Sales Current Account % GDP Budget Balance % GDP 10 Year Yield US 1.90% 2.50% 4.70% 0.01% 5.60% -2.55% -3.10% 2.58% EUR 1.70% 2.00% 9.60% 2.00% 1.20% 3.37% -1.60% 0.44% UK 2.00% 1.80% 4.80% 3.20% -0.20% -5.06% -3.01% 1.22% CAN 2.59% 2.10% 6.60% 2.27% 4.30% -3.34% 0.10% 1.82% Central Bank Bias Current Rate Last Change Date of Change Next Meeting Likely Next Move UK 0.25% -0.25% 4 th August th March 17 Unchanged US 0.50% - 75% 0.25% 14 th December th March 17 Hike CAN 0.50% -0.25% 15 th July th April 17 Unchanged EUR 0.00% -0.05% 10 th March th April 17 Unchanged 7

8 Appendix - Primary Indicator Methodology 1. Momentum The momentum indicator is based on four metrics - 1 week change, 1 month change, 8/15 day moving average and 10/25 day moving average of the spot rate. We look at the direction of movement of each metric in the previous week (increase or decrease) and then assign a final score. For example, if all metrics moved up, we assign an Extremely Bullish score. Movement in metrics Score Extremely Bullish Bullish Neutral Bearish Extremely Bearish 2. Carry We calculate carry based on the difference between interest rates in two respective countries for each currency pair. See below for score assignment: Carry Score > 1% Extremely Bullish < 1% and > 0.5% Bullish < 0.5% and > -0.5% Neutral < -0.5% and > -1% Bearish < -1% Extremely Bearish 3. PPP Valuation In order to determine whether a currency pair is over or undervalued, we use CPI, PPI, OECD, Goldman Sachs and IMF fair values, calculate their average, and compare it with the spot price. Depending on the magnitude of divergence of the spot from the fair value, we assign a specific risk score (see table below): Valuation Score > 15% Extremely Bearish < 15% and > 5% Bearish < 5% and > -5% Neutral < -5% and > -15% Bullish < -15% Extremely Bullish Disclaimer: The Information is not intended to be a complete statement or summary of securities, markets or developments referred to in the document. Validus does not undertake to update or keep current the Information. Any opinions expressed in this document may change without notice and may differ or be contrary to opinions expressed by other business individuals or groups of Validus. Any statements contained in this report attributed to a third party represent Validus's interpretation of the data, information and/or opinions provided by that third party either publicly or through a subscription service, and such use and interpretation have not been reviewed by the third party. Nothing in this document constitutes a representation that any investment strategy or recommendation is suitable or appropriate to an investor s individual circumstances or otherwise constitutes a recomendation. For advice, trade execution or other enquiries, clients should contact their representative. 8