Currency Hedging Premium in the Era of Trump

At times of financial panic such as during the 2008 meltdown the cost of hedging currency risk goes up. In normal times when it became more costly to buy dollars implied interest rates went up in excess of the rates in cash markets. Banks arbitraged away the difference and all was well. This becomes more difficult when the market is uncertain such as now. There appears to be a currency hedging premium in the era of Trump. Bloomberg says this fear gauge is ringing alarm bells today.

Once viewed as a law of finance known as the covered interest rate parity condition, this market dynamic unraveled during the global financial crisis and then again during the euro-area sovereign debt debacle, amid a spike in counterparty risk and a sharp reduction in dollar funding to non-U.S. banks. These two strains – a key barometer for risk appetite and financial stability – have eased relative to the heights reached during the crisis.

Now a bevy of forces, including banks continuing to downsize balance sheets and money market reforms, have conspired to increase the structural costs of currency hedging relative to the pre-crisis heyday. And things just got notably worse.

As the U.S. dollar surged in the wake of the U.S. election, cross-currency basis swap spreads have been strained. In short, investors in the yen and euro seeking to hedge their dollar obligations are now forced to pay an effective Trump premium.

The fallout from this situation is not just in the cost of hedging currency risk but in expected dollar shortages across Asia in the coming year. This will affect transactions across the board and further drive up the cost of hedging on the dollar in the era of Trump.

Currency Risk Outweighs Business Risk

Businesses that buy and sell things overseas always need to hedge currency risk. However, that risk is typically a fraction of the profit involved in the transaction. That may no longer be the case in the era of Trump. Investment Week notes that today currency drives returns on investment.

Currency exposure has been the main driver of gains for many UK investors this year, but managers are now turning their attention to hedging strategies as they predict further volatility in the FX market, while some are becoming more bullish on sterling.

This year has seen the pound plummet to a 31-year low after the UK voted for Brexit on 23 June, trading 15% lower against the US dollar year-to-date at $1.2521 and down 13% against the euro at €1.1795 (as at 1 December).

Sterling weakness has boosted UK large caps in particular, which derive a large proportion of their profits from overseas.

In the era of Trump it has become more important to bear the cost and hedge currency risk than to cost effectively make and market your products. All of this is based on the dollar rally and assumption that it will continue. Is that the case?

How Secure Is the Trump Dollar Rally?

Business Insider looks at what could kill the Trump dollar rally.

“We would not argue with the logic and our revised forecasts since the election incorporate a stronger USD,” and HSBC team led by strategist Daragh Maher wrote in a note to clients. “Nonetheless, there are many moving parts to the Trump policy agenda and the market risks missing drivers in its myopic focus on fiscal policy alone.”

More concretely, HSBC detailed four items, noting that it’s not a 100-percent-guarantee that the index will keep advancing.

The four factors they cite are fiscal policy, overseas income repatriation, trade policy and immigration policy. Loosening of fiscal policy and repatriation could help the dollar but his immigration policy will not help and if he gets the US into a trade war all bets are off. All of this is why there is a currency hedging premium in the era of Trump.