Hedging opportunities on interest rates

Hedging opportunities on interest rates

24 August 2022

Recently, inflation figures for the US for July were released and the stock market was buoyant. European stock markets also rose on the news and the Nasdaq was no longer in a bear market by the definition that the market has fallen by more than 20% over a long period of time. Before, there was speculation that this was just a brief stabilisation of the markets but now the question is whether the worst is over.

There are several factors that will affect inflation going forward but clearly the price of commodities such as oil and gas have partly driven the soaring prices as has the availability of semiconductors and transport costs which have increased. Inflation expectations have also been in place and wage increases have been higher than the 2% inflation target, which is not conducive to stable inflation. In general, expected inflation and actual inflation tend to be relatively consistent. Inflation expectations among money market participants fell slightly in August, which, together with the lower oil price, gave us some breathing space.

Unlike the stock market, the fixed income market continues to be priced on the basis that we are heading towards a recession. This can be seen in the inverted yield curves where shorter US Treasury bonds yielded more than those with longer maturities did. However, we have now returned to a more normal mode. Not only in the US did inflation fall on a monthly basis, but also in Sweden it fell, but according to the Swedish central bank’s forecast of inflation (on an annual basis) it will remain around the current level for a while and only move downwards towards the inflation target of 2% annually at the beginning of next year.

Yield of US Treasury Bonds

Above: Yield in percent.
Source: Federal reserve bank of St. Louis. Note: Past performance is no reliable indicator of future results..

The Swedish central bank’s forecast can be seen as very optimistic as it is based on following developments over the past month. If one draws parallels between inflation and the price of commodities, freight costs and the availability of semiconductors, it is difficult to predict what would happen if we entered a situation similar to the situation in spring. With the uncertainty that remains, there are many aspects to consider when forecasting inflation and this crisis is unlike any in history with low unemployment and lots of job vacancies. Future monetary and fiscal policy actions will be based on inflation figures in the coming period and much that is being done is to put out temporary fires. On 14 of September, Statistics Sweden will give an indication of inflation in Sweden. The central bank of Sweden will then announce its policy rate on 20 September and if current expectations hold, we could see a hike of around 50 to 100 basis points.    

How might this affect investors? Everything from equities to financial securities is affected by interest rate announcements and before interest rate announcements and inflation figures, the market tends to be very volatile historically. As an investor, there are long-term as well as short-term opportunities to stabilise your portfolio or increase your exposure to asset classes and markets.

So how can you hedge a portfolio for uncertainty?

So, to start with, let's take an example where you as an investor have a portfolio composition that is exposed to the US as well as the Swedish market. In this example, the portfolio follows the S&P 500 index, Nasdaq-100 index and OMX index relatively well. If you as an investor believe that the market will go towards a bear market but at the same time you do not want to sell off holdings in your portfolio, it is possible to hedge the portfolio. In a hedge, you should generally not try to make an optimal hedge where you hedge your entire position and eliminate volatility completely as it is almost theoretically impossible and in an optimal hedge you eliminate the possibility of returns. But of course, it all depends on the risk you are willing to take. If you are an investor with a portfolio of US equities and you think the Fed will raise interest rates that will affect your position, you could hedge with a Bull & Bear, Mini Future or Unlimited turbo, for example.

If you hedge your entire holding, you can use leverage as a reference in how large a position you can take. Based on your own expectations and risk, you choose the leverage and stop loss for Mini Futures to the level you want to achieve. For example, if you as an investor believe that a Bear market will only occur as long as the market moves sideways by +-5%, you can take a short position with a stop-loss level of 5%. To determine the position, you could use the amount of capital you want to hedge divided by the leverage of the Mini Futures. In this way, you could reduce the volatility of your portfolio at certain times. What is worth bearing in mind is that the larger the stop loss you seek, the more expensive the hedge will be due to the lower leverage you get.

How do interest rate rises affect exchange rates and how can you hedge?

Interest rates also have a major impact on exchange rates between currencies as investors look to countries where the interest rate market offers the highest returns. When a market offers higher yields, investors move capital to that market. This also affected the USD/SEK and EUR/SEK exchange rates where the Swedish krona has weakened significantly recently. Weaker currencies and fewer investors are affecting both investments and share prices. At the same time, it also makes it more favourable to export but more expensive to import, which could lead to higher inflation. With more movement in exchange rates, the risk of currency losses increases due to contracts where payment is made at a future date in another currency increases, affecting Swedish companies that produce complex products with longer delivery dates. For example, a contract where a Swedish company chose to buy US components a year ago with delivery today has become 20% more expensive simply because of the fluctuation in the exchange rate. This leads to reduced margins. It is of course also possible for you as an individual to hedge your holdings against currency risk such as a weaker or stronger krona. In this way you can increase your exposure to exchange rates or minimise your exposure.

Important legal information

Legal notice

This information is neither an investment advice nor an investment or investment strategy recommendation, but advertisement. The complete information on the trading products (securities) mentioned herein, in particular the structure and risks associated with an investment, are described in the base prospectus, together with any supplements, as well as the final terms. The base prospectus and final terms constitute the solely binding sales documents for the securities and are available under the product links. It is recommended that potential investors read these documents before making any investment decision. The documents and the key information document are published on the website of the issuer, Vontobel Financial Products GmbH, Bockenheimer Landstrasse 24, 60323 Frankfurt am Main, Germany, on prospectus.vontobel.com and are available from the issuer free of charge. The approval of the prospectus should not be understood as an endorsement of the securities. The securities are products that are not simple and may be difficult to understand. This information includes or relates to figures of past performance. Past performance is not a reliable indicator of future performance.

05/12/2022 17:48:48

 

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