Is currency hedging worth the risk?

Over the first half of 2022, sterling and the euro have both fallen by more than 10% against the US dollar. While that may seem like a significant move, sterling has fallen or risen by more than 10% against the dollar over a six-month period on 16 occasions since 2000.

Currency markets are very volatile and large movements in exchange rates are common and can have a significant impact on the value of different asset classes.

This raises the question: should investors hedge currency risk?

In this blog, we set out how we think about currency hedging from a strategic perspective for a range of different asset classes, before taking a deeper look at current conditions and patterns in currency markets that some investors might consider as a tactical position.

Strategic currency hedging

The overwhelming majority of investors will have some sort of overseas currency exposure in their portfolios. Currency markets are often volatile, meaning that even “normal” moves can have a significant impact on unhedged assets. A 10% rise in the value of sterling relative to the US dollar will translate to a 10% fall in the value of your unhedged US equities, all else being equal.

We believe that your strategic position should be to hedge a significant proportion of currency risks. For more information on how we see this conclusion varying by asset class, expand the drop down boxes below to find out more about different currency hedging strategies.

Tactical currency hedging

Now that you have your strategic approach, should you make tactical adjustments away from that position? Can you gain additional returns, or reduce volatility of overall returns by taking tactical underhedged or overhedged positions?

In short, we think such opportunities are difficult to predict and are infrequent. However, investors willing to commit a little more time and governance budget can, though, start to think about such tactical adjustments (where permitted by the regulatory regime that they must comply with). To do this you first need an understanding of what drives currency dynamics and how these dynamics change during extreme events.

^{Figure 1: Exchange rate of sterling against the US dollar; Source: Bank of England}

Currency dynamics

Monetary policy

The long-term central tendency of a currency is determined by that country’s expected growth, trade balance and other fundamental economic factors relative to the rest of the world. But movements around this central point are largely determined by monetary policy. If, for example, the Bank of England raises rates faster and higher than other countries, sterling will tend to appreciate and vice versa. Quantitative easing has an impact too – if a central bank is increasing the supply of money (relative to another country) then the exchange rate will tend to fall. 

So, investors looking to take advantage of currency movements should focus on relative changes in monetary policy, both interest rates and money supply, compared to what the market has already priced in.

Changing fundamentals

From time-to-time some other event will result in a change in a currency’s central value if the economic fundamentals are expected to change significantly. A recent example of this in the UK was the Brexit referendum. These kinds of events are difficult to forecast ahead of time but where they can be anticipated, such as a potential Scottish referendum, we would recommend a higher level of hedging than you would normally take ahead of the event. 

Extreme events and "safe-haven” currencies

Some currencies are considered “safe-haven” currencies and have a reputation for rising in value during crises, such as the US dollar, the Japanese yen and the Swiss franc. As the US makes up over 60% of most global equity indices, an unhedged position will usually result in a significant exposure to the US dollar. This means that a degree of unhedged exposure could protect against the worst of the downside during a crisis. 

We can test the impact of “safe-haven” currencies by looking at sterling performance against the US dollar during the Global Financial Crisis (GFC) and the COVID-19 pandemic (note: the performance of the yen and Swiss franc against sterling were similar to the US dollar). 

• The GFC saw sterling fall more than 30% against the US dollar in the six months to its trough in January 2009 from around $2 to around $1.40. This can, though, be partly explained by the relatively high exposure of the UK economy to the financial sector. By June 2009, nearly a year from the pre-crisis peak, it had found a new equilibrium at around $1.6. 
• The COVID pandemic caused a similar spike in the US dollar in March 2020. However, much of the spike had dissipated within two weeks, and it had done so entirely by August 2020.

^{Figure 2: Sterling devaluation against the dollar during major crises; Source: Bank of England}

COVID-19 Pandemic start date of 19 February 2020, GFC start date of 1 August 2008

The GFC depreciation lasted for so much longer and stayed more persistent because it reflected a larger financial crisis, but also because it reflected a relative change to economic fundamentals between the UK and US. Whilst the impact of COVID is still playing out, a similar change has not yet been seen. However, both experienced periods of sterling depreciation larger than implied by differing monetary policy. Therefore, an unhedged position against the US dollar (or other “safe-haven” currencies) during crises can be beneficial. 

Such events are, though, not all that common. They are also very difficult to predict. Investors will need to consider whether they hold such positions over short time periods in order to try to capture any opportunities (a tactical position) or whether a lower level of currency hedging is held in respect of some currencies relative to others over the long term (a strategic position). Investors should also be aware that if an unhedged position is held (whether tactical or strategic), safe haven currencies do not always protect returns – see below for an example with the Japanese yen. 

How have “safe haven” currencies performed recently?

Over the first half of 2022, equity markets have fallen by more than 17% and many would expect to see the “safe-haven” currencies to have strengthened during such a disruptive period. Most currency movements over the year to date are better explained by relative changes in monetary policy expectations (with one exception being the Swiss franc which has appreciated relative to sterling as expected in a time of market downturn).  

For example, the Japanese yen has depreciated relative to sterling over 2022 as the Bank of Japan has not felt the need to raise interest rates. In contrast the US dollar has risen as the Federal Reserve began to raise rates faster than the Bank of England.

^{Figure 3: Impact of differing central bank policies on exchange rates over 2022; Source: Bank of England}

Therefore, the impact of an unhedged position in “safe haven” currencies is sometimes limited. 

The Swiss franc has, however, shown the dynamics that would be expected of a “safe haven”.

So what’s next for currency hedging?

In our view, investors should have a conscious and logical approach to their exposure to currency risks, including fully hedging their fixed income exposure. 

Strategic target

• For developed market equities, investors should consider a strategic hedging level somewhere between 50% and 100% of foreign currency exposure. Anywhere in this range will provide most of the benefits of hedging. 
• Most fixed income exposure should be fully hedged. A possible exception to this is high yield bonds, which can follow a similar argument to developed market equities. 
• Emerging market exposures may be left unhedged. 
• Decisions taken by active managers should be monitored.
• Investors with higher levels of governance may consider lower levels of hedging for some currencies. 

Tactical positions

When making tactical hedging decisions, you should consider whether:

• The fundamentals of the UK economy are expected to improve relative to the rest of the world,
• UK monetary policy is expected to tighten faster than expected, or  
• There is an imminent crisis in global markets.

In the absence of any of the above, stick to your strategic hedging position. Unhedged positions may be bad news for your returns!

If you have any questions, please do contact the author, or your regular investment consultant at Barnett Waddingham.