Given the sharp rise in interest rates, should I wait to hedge? When will be the good window? What is the winning strategy in this situation? These are the questions that the entire market is asking. You will find the answers in this letter.
Topics: Market risks / Uncertain Environment / Optimal strategy
That man is prudent who neither hopes nor fears anything from the uncertain events of the future, wrote Anatole France in Mother of Pearl in 1892.
Soaring inflation rates, skyrocketing interest rates, a rapidly appreciating US dollar and exploding gas and electricity prices: the period of turbulence in which markets have entered is worrying.
But what if this was just the beginning? What if inflation remained stuck at 10% or thereabouts persistently; what if interest rates rose and remained at 10%, while the euro plunged still further against the dollar? What if, on the contrary, we saw a swift return to negative interest rates in the euro zone due to a severe recession? Are these scenarios possible? Are they likely?
“Because of the fog in front of him, he did not see that he was only at the start of the mountain.”, Unknown author
This quote seems all too relevant here.
Financial markets may be short-sighted and suffering from amnesia, but we could say the same about central bankers. Who among the members of the European
Central Bank had predicted an inflation of more than 10% in Germany in 2022? Just a year ago, this seemed virtually impossible. Predict the future is equally impossible.
The current volatility is the result of shocks that were very difficult, if not impossible, to predict
Spiralling rates
Over the last year, Euro long-term rates have risen from 0% in September 2021 to more than 3% in September 2022.
And as usual, we have been at ESTER asked for our opinion on this:
- Do you have a forward view on the market?
- What do you recommend in terms of timing?
We were asked these questions when the 10-year rate reached 0.50%, then 1%, then 2%, and again at 3%. On each occasion our clients had the feeling that the rise was disproportionate and that a return to normality was imminent. And there have indeed been corrections, for instance in July when long-term rates lost 100 bps very rapidly, going from 2.50% to 1.50%, but to then shoot back up subsequently.
Evolution of the 10Y Mid-swap rate from January 2020 to October 2022
Obviously, an understanding of context, the use of models, and the benefit of market experience make it possible to understand, to explain, and to measure the risks. It is important to share those views. However, nobody can claim to know what is going to happen.
At this time of great uncertainty, if we cannot trust market predictions to make our hedging decisions, then what can we rely on to support our decisions?
The answer we give is always the same:
Understand the risks to which your project is exposed and quantify them, including in extreme scenarios.
Determine whether those risks are acceptable and study strategies to hedge risks that are deemed unacceptable.
Choose a hedging strategy that reduces the risk and understand the change in the risk profile that results from the implementation of the hedging strategy.
That being said, let’s take some time to consider the most frequently asked questions:
Market rates have increased too much. It is now too late to hedge
Market players have a natural tendency to analyse the level of rates with regard to known or experienced history. And to suddenly revise their assumptions at each paradigm shift. This is why, during the long recent history of falling rates, it was deemed impossible that short-term rates could fall below 0, then it was accepted that short-term rates were negative, but it was thought impossible for long-term rates to go into negative territory. Eventually, the market got used to this, and the argument was heard that the rates would never go up again. This persuaded some to recommend very light hedging.
The trend having reversed, we have seen the same phenomenon in the opposite direction: when long-term rates reached 0.50%, it seemed that the rise having already occurred, it was now too late... and then at 1%, at 1.5%, … 3%.
In this context, there are two principal reasons given for not hedging:
Hedging at these levels destroys the project’s profitability: This reasoning could be valid if in the end, the cost of abandoning the project in the event of further rate increase is bearable for the sponsors.
The rates have reached their peak and can now only decrease: In general, the market puts a probability of around 50% on the rate reduction scenario (compared to forwards) and to 50% also on the rate increase scenario. So, taking this view is acceptable if the cost of the 50% rate increase scenario is bearable for the company or for its sponsors.
The principle is therefore not to base decisions on past market trends, but to analyse risks associated with future market movements and their consequences on the project
Market players who have adhered to this approach in the recent months have avoided many disappointments.
What if the implemented hedge turns out ex-poqst to be a "losing stragegy" ?
A hedge has approximatively a 50-50 chance of turning out to be a ‘losing strategy’. But a hedge is not implemented on a stand-alone basis. It is part of a whole with the hedged risk and must therefore be analysed in this context.
Obviously, it is always easy to claim afterwards that implementing a hedge was inappropriate. But, if the work was properly done and the hedge was justified at the time as a way to reduce the risk in accordance with the risk appetite, without unacceptably degrading the performance in the various scenarios envisaged when of setting it up, and if all the stakeholders were involved in the decision, there is then no basis for making such an ex-post judgment.
The validity of a hedging decision shouldn’t be judged on the basis of post-execution rate movements
Of course, rates may drop after the hedge has been put in place, just as a rise in rates may occur.
However, the fact that your house hasn’t burned down doesn’t mean that you were wrong in continuing to insure it. By the same token, a strategy aimed at reducing risk can only be judged according to this criteria: was it important to reduce the risk, and did the strategy that was implemented succeed in doing so? Yes? Then it was the right decision.
What is the winning strategy the implemented hedge turns out ex-post to be a "losing stragegy" ?
The winning strategy is the one providing the best combination between risk and performance, for a given risk appetite. The first step is therefore to define the risk appetite.
The second step is to try, as accurately as possible, to measure the risk, which has many varieties: the project risk with its base-case and worst-case scenarios, the interest rates risk, the exchange rates risk, inflation, liquidity, credit, and so on. These risks are interconnected and correlated. A probabilistic approach that takes account of the effects of correlation between the various risks can bring a lot of added value to the understanding of the risks and to the decision-making.
The third step is to define a strategy that eliminates unacceptable areas of risk without too much deteriorating the performance in the central scenario, and without creating new unacceptable risks. This last point is crucial, and too often neglected. To give an example, a hedge against rising rates could expose to unlimited risk in the event of falling rates, if an interest rate swap without a floor is backed by a variable rate debt whose index is floored. There are plenty of examples where a poorly thought-out strategy can generate more or less serious inefficiencies
What is the right window for executing the hedge ?
Once the analysis is completed, the decisions have been taken, and all the conditions are met for executing the hedge, one should not wait
There are certainly punctual windows that should be avoided, for instance just before the publication of particularly significant economic figures. On the other hand, acting as though you could predict the market’s movements afterwards is a fool’s game – at best it is simply an excuse for inaction.
Since the purpose of hedging is to reduce risk, there is no real reason for delaying the execution. How disappointing it would be if a risk identified was to materialise when one had deliberately decided to wait!
Conclusion
Understanding the market situation is a legitimate goal that the hedge advisor must be capable of achieving. However, since no one can predict the future with a sufficient degree of certainty, and since a binding decision must be made in the end, the analysis of the risks and expected returns under different scenarios should always take precedence over questions of timing and speculations about the likely future evolution of the markets – something that in reality no one can predict with enough confidence.
An inadequately hedged project that becomes unprofitable for the wrong reasons will always be a bad project.
Therefore, rather than trying to read the future, let's work together to perform the analysis that will allow you to decide with confidence whether to hedge or not your projects.