Murray Bender: RBC Investor & Treasury Services is pleased to present insights on the future of asset and payment services across the globe. Coming up on today’s podcast is Mark Hogg, Head of FX Product at RBC Investor & Treasury Services, discussing some of the currency risk issues facing global investors in today’s volatile economic environment. Welcome, Mark.
Mark Hogg: I’m pleased to be here today, Murray.
Murray Bender: To kick off our discussion, Mark, what challenges are the current inflationary pressures and central bank interest rate increases adding to currency risk management?
Mark Hogg: Thanks, Murray. And yes, I think we’re at a crossroads in markets now, where the super-low-interest-rate environment that we’ve all become so accustomed to is coming to an end. And when you think about it, we definitely have a whole generation of traders and investors that have never experienced a normal—and by that, I mean by long-term historical standards—interest rate environment.
All that is coming to an end now. As we look at the road ahead, we can already see a big shift in the mood music coming from markets as the macro environment deteriorates and as central banks are fighting down the prospect of runaway inflation.
And there really is a difficult job ahead for policymakers to try and now thread the needle between setting monetary policy that’s going to dampen all these inflationary pressures, but also while trying to minimize the potential damage to economic growth and not to push the world into a recession.
We also have to really acknowledge that there’s only so much that can be accomplished with monetary policy alone. Many of the problems we see now are physical, real-world problems in the form of product shortages and disruption to raw material supply chains, and so on.
But look, at the risk of getting too far off-topic and turning back to what does all this mean when we think about currency management, well, there’s a couple of points I would call out.
And the first is that interest rates, and more specifically, the differences between interest rates, are going to become a much more important factor into currency hedging decisions.
If you take, for example, the market cost to hedge a US dollar asset exposure to euro using standard FX forward interest rate, so nothing too exotic, markets are pricing in that US interest rates are going to be about 2.5% above euro rates by the end of this year. The expectation there is that the Fed are going to increase rates at a much faster pace than the ECB.
And in that scenario, the interest rate differential of 2.5%, that’s going to add to the cost of hedging the US dollar exposure to euro, and that compares to around 1.5% today. And so those types of interest rate differences are going to become a more important input into decision-making.
The second point I would make is that both investors and market practitioners should also plan for more volatility in interest rate forecasts. The market’s finding itself now in kind of unfamiliar territory where it’s having to try and price in long series of rate increases into the future. And I would expect that we’re going to see plenty of fluidity and uncertainty around rate path predictions as we move forward from here. So currently, hedgers who lock in longer-dated contracts may find themselves exposed to much more interest rate risk than they had anticipated.
And the last point I would make is that we can probably expect that we’re going to see a lot more volatility in FX spot rates. The search for yield has always driven macro currency flows, and we can see that further accelerate now.
But if you overlay that with these somewhat unpredictable central bank actions and volatility in markets more generally across all asset classes as they adjust to this new environment, and I think we’re setting the stage with the potential now for some really big moves in FX rates in the period ahead.
Murray Bender: Mark, as yields rise and fixed income securities potentially become more attractive, what are the currency risk considerations for global investors?
Mark Hogg: I’m sure I’m not alone, Murray, these days in scratching my head and finding it difficult to know where to protect and to grow your savings and your investments. Year to date, both equities and most fixed income portfolios are showing big losses.
However, with fixed income yields starting to rise across the world, for the average investor, the risk-reward is going to start looking much more interesting for bonds, and that could bring a lot of fresh inflows into fixed income security funds.
Many of those investors might also like to spread their risk over a global portfolio of these securities. And by doing so, you might expect to receive reasonably stable and predictable returns. However, in that scenario, what you really need to pay attention to is the currency risk. Hopefully, the bonds do their job, and they provide somewhat lower volatility return investment.
But the FX risk component of translating those foreign currency bonds back to your home currency, that can be very significant. And I’d predict that we’re going to see more demand for product providers to deliver currency-hedged products in that fixed income space and to give investors the choice of managing that currency risk separately to their choice of asset class.
Murray Bender: In your view, Mark, what should investors be focusing on in light of the fact that major currency pairs are now breaking out of multi-year ranges?
Mark Hogg: We are now getting towards what I call the outer limits of multi-year long-term ranges for a lot of major currency pairs.
If you look at the sterling versus the US dollar, for example, it’s grinding down towards lows that we haven’t seen since the Brexit vote in 2020. And before that, Murray, you have to go all the way back to the 1980s, early 1980s, in fact, before you see the sterling versus the dollar below 1.2.
And similar situation evolving with the euro versus the dollar, which is now trending towards parity. And you have to go back about 20 years since the last time we saw that.
So these are the types of moves, long-term moves that can really impact your investment returns on pension fund assets denominated in foreign currencies, for example, or even your personal investment choices, obviously, depending on your home currency perspective and your holding period.
And the worry is that decisive moves outside of these ranges could speed up some of these trends even more. You can also look to minor and emerging market currencies, and in those cases, you see some even more amplified moves.
But you look at popular markets like Brazil and India, their currencies just continue to trend lower, lower. And while you might expect that by being in those markets, you were in a higher long-term recurrence in local currency, to certainly losing ground in terms of your home currency over time by the depreciation of that local currency.
But I guess the key message from all of this is that, if you are an asset owner, you should think strongly about separating your investment decisions into asset and currency, and then manage your risk appetite for each component separately.
And if you’re an investment manager, then make it easy for your clients to access your products in a currency-hedged format so that they can then tailor their own appetite for currency risk.
Murray Bender: Looking to the future, Mark, what industry and market trends do you see shaping the management of foreign currency and hedging programs going forward?
Mark Hogg: You and I have spoken about this before, Murray, and we continue to see a few key trends or market forces that are shaping the landscape for currency execution and hedging programs when we look forward.
The first and probably the most obvious one is downward pressure costs. And that can come in multiple forms, for example, pressure to reduce asset management and asset administration fees, or for asset owners and investment managers to reduce their operating costs and bring more focus onto their core strengths and distribution, and to shared activities that can be effectively outsourced to expert partners.
The second point, and I guess it’s closely aligned to the first, is just how good digital and technology solutions are now getting at automating complex workflows and processes, and importantly, without sacrificing any control or oversight. There’s much more intelligence and data-led insights in these automated processes now.
I’d also add that, things that in the recent past that we might have considered to be product differentiators or value-added features for currency execution and hedging products, they’re quickly becoming table stakes today. You say things like embedded transaction cost analysis, execution oversight dashboards, data visualization, performance analytics, electronic documentation solutions, flexible online reporting portals, flow in architecture, I could go on. But all these things are now expected as standard.
And the final point I’d make is that we can’t, and we should never forget the importance of client experience and in doing the basics seamlessly day in and day out. This is something we all have to put extra focus on.
More and more, all of our attention spans, they’re stretched in so many different diverse topics and we’re chasing the next big thing. And I often hear from clients that it’s basic avoidable errors, and the noise and the frustration that those things create for everyone, that just expends so much unnecessary energy.
And so I think that providers that do the basics well quietly get on with keeping their clients’ day-to-day operations as pain- and as hassle-free as possible, I think they stand to do very well in the future.
Murray Bender: Lots to think about, Mark, that’s for sure. Thanks for joining us today, and we really appreciate it.
Mark Hogg: It’s been my pleasure, Murray.
Murray Bender: For additional insights on topics relevant to corporate investors and financial institutions across the globe, including our previous podcasts, visit rbcits.com/insights.
I’m Murray Bender. Thanks for listening.
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