25 April 2018
FX: Are corporates reconsidering US dollar hedges?

With US dollar hedging costs high, EUR/USD closer to fair value and the ECB story on hold, European corporates may be reconsidering their high hedge ratios on USD receivables

Corporates less convinced about a big dollar decline?

We may be a little premature in discussing this topic, but in speaking to some customers we are getting a sense that high US dollar hedge ratios are being reconsidered. In other words, corporates are possibly becoming less convinced about a further large dollar decline and, where hedging mandates allow, over coming months could be scaling back some of their more aggressive USD hedging.

While most corporate FX hedging decisions do sit within clear mandates, there is typically a little room for discretion. For example, when EUR/USD was below 1.10 in late 2016 and early 2017, larger European corporates typically held the view that the USD was overvalued (most fair value readings were in the 1.25 area) and that hedge ratios on expected USD receivables should be higher, e.g. closer to the top end of the 50-100% range and should cover longer tenors. Here, treasurers made special requests from the board to extend the horizon for USD hedging.

USD: Return of the king or just a breather from a crowded short trade

The sharp 2% bounceback in the broad US dollar index has raised some eyebrows and led to questions whether this is a new trend. But FX positioning data shows this has all the hallmarks of being another short USD squeeze - which has historically been short-lived 

Key messages: Crowded FX positions unwind

  • The sharp 2% bounceback in the broad USD (BBDXY) index over the past week has raised questions over whether this is the end of the dollar bear trend - or whether this is merely a pause as investors take stock of what the next big narrative in global markets will be. We believe it's a classic case of the latter - not least given that we've had a strange week or so of low Trumpian noise, while the extremely crowded positioning in G10 FX markets also lends itself to a bit of a breather in the medium-term USD downtrend. 
  • When looking at G10 FX price action, we note that there is a clear link between positioning and year-to-date performance (yes it's not rocket science!). As the second graphic below shows, those currencies that have had the largest bullish positioning adjustments in 2018 (Sterling, New Zealand dollar, Japanese yen, Euro and Mexican peso) have also been the clear outperformers this year. Equally, the currencies with the biggest net long positions as of mid-April (MXN, NZD and GBP) have also been the ones that have sold-off the most against the USD over the past week. The clear link between FX positioning & performance means that the 2% USD rally has the hallmarks of being nothing more than a short squeeze - fuelled by (1) local factors (weak data for GBP and NZD; presidential election risks for MXN) and (2) a lack of impetus in the recent drivers for USD weakness.
  • The EUR is a slight anomaly here in that its weakness this week hasn't been as pronounced as its long positioning would suggest - though we chalk this down to (1) some focus on this week's ECB meeting and (2) the fact that EUR long positioning has been a function of growing bullish sentiment amongst real money investors - who are happy to play the 'long game'. For more see our April ECB Meeting Crib Sheet
  • A sharp squeeze in short USD positions is not surprising given the lack of further impetus in the array of weak USD drivers - namely US political uncertainty (stemming from either trade or geopolitical risks), a sell-off in relatively expensive US assets or a strong Rest of the World growth story. Equally, it seems that initial dawning of more structural forces like the rising US twin deficit - and the administration's implicit weak USD policy - has already taken place. These structural narratives may require something (maybe a policy announcement or tweet) to once again become active - though we do believe that they will continue to exert downward pressure on an overvalued US dollar over the coming quarters.
  • Looking at previous occasions when we've seen a similar sharp squeeze in short USD positioning, we note that the follow-through into USD spot price action has been fairly short-lived. On average the BBDXY index has been 1.1% higher after two weeks - after which there is no clear pattern to which direction the USD will take. If we take the most recent episode - October 2017 - as a precedent, then we could see the USD remain at these elevated levels for around three-four weeks - before the next wave of weakness kicks in. But given the high degree of uncertainty around US trade and foreign policy, we're aware that we may be only one tweet away from this coming much sooner.
US GDP: The Q1 conundrum

US GDP readings for the first quarter are by far the weakest in any given year. Given our 2.4% forecast for 1Q18, this trend suggests 2018 will be fantastic

What's wrong with Q1?

As with most economic data, GDP is also seasonally adjusted to take account of the influence of things such as predictable weather patterns, school term dates or national holidays. For example, severe weather in the winter means construction work grinds to a halt while consumer spending typically gets a lift in the build-up to Christmas. Economists prefer to try and eliminate these patterns to make it easier to observe the "true" underlying cyclical trend.

Yet, looking at quarterly GDP growth rates, there is a clear pattern of underperformance in the first quarter of a year. Going back over 30 years, we find the average quarter on quarter (QoQ) annualised growth rate for a Q1 is 1.7% versus 3.2% for Q2 and 2.5% each for Q3 and Q4. Since the start of the financial crisis, the problem seems to have worsened with Q1 averaging 0.17% versus 2.4% for Q2, 1.9% for Q3 and 1.4% for Q4. Seasonal adjustment means Q1 growth should not be consistently different from any other quarter, so there is clearly some "residual seasonality".

Why the US 10-year should settle in the 3% to 3.5% range

Has the US 10-year Treasury yield peaked? We’re not convinced and think it's likely to breach 3%, possibly within the next few weeks

Getting a good steer on the US 10yr Treasury yield is important, for a few reasons.

It is the global benchmark market rate; movements in it cause reverberations across rates and bond markets extending from core rates to corporates and emerging markets. Crucially, it also provides a long-term nose for where the Fed funds rate may eventually converge towards (compensated by term premium). So, it matters. 

The big question is, has the 10yr rate peaked? We’re not convinced it has. Currently, 2.98%, we expect it to cross 3% perhaps within the next few weeks, with fundamentals, positioning and technicals as the key drivers. We employ our model for interest rates, to get an unbiased handle on a fair valuation of market rates.

US: Are we heading to recession?

The US yield curve keeps getting flatter with growing concern it could turn negative. Such a development preceeded all nine recessions since 1955. How worried should we be?

Yield curves and the economic cycle

The US yield curve is currently the flattest it has been for a decade. With the Fed looking set to hike rates another three times this year a growing number of voices are warning we could soon see the yield curve actually invert, meaning it is cheaper for the government to borrow over ten years that it is over 2 years. This is a huge story. When the yield curve has inverted previously it’s been an early warning signal of impending doom - the US has typically fallen into recession within 2 years.

Reading time around 7 minutes

US: A milestone, a short squeeze and a Q1 conundrum

The 10-year Treasury yield has finally hit 3% after four years, the dollar rally is showing all the hallmarks of a short squeeze, European companies might be scaling back some of their more aggressive dollar hedges and we still expect the Fed to hike three times this year with a further two, possibly three in 2019

In this bundle