Market practitioners have kicked off 2017 with expectations of a tightening monetary policy and brighter corporate and economic fundamentals. With this in mind, BMA shares its house view on a few trending investment themes and offers examples of risk management solutions from the BMA toolkit.
Theme #1: Rising Interest Rates
The Federal Reserve increased the overnight lending rate in December from 50bps to a target rate of 75bps. The Fed also shared its projections of at least three rate hikes in 2017 by nearly 65% of the Committee. As a result, the interest rate curve has steepened with the expectation that long-end rates (10-years and beyond) will continue to edge up. An indication of a steeper curve is the widening of short-term and long-term interest rates as shown below:
Solution: Consider minimizing duration risk or one’s sensitivity to interest rate moves in the short-end of the curve by remaining floating up to two years and/or by buying disaster protection with an out-of-the-money interest rate cap. Regarding the long-end, lock-in potential moves through a pay-fixed swap. Hedged ETFs may be prudent if it falls within a given investment mandate.
Theme #2: Oil Prices to Rally ~$60
Crude oil prices have increased since the Organization of the Petroleum Exporting Countries agreed to scale back production in September. Higher oil prices tend to bode well for some commodity-focused currencies including the Canadian dollar, Russian ruble and Colombian peso.
Solution: Consider a foreign exchange hedge, such as short dated forwards or long dated options to manage FX exposure. Forwards tend to be an inexpensive tool to manage currency risk as it does not require an upfront payment. From an investment perspective, an increase in oil prices generally indicate higher long-term bond yields, greater interest in Treasury Inflation Protected Securities, emerging market securities and a move away from safe-haven assets.
Theme #3: Increased Volatility
Geopolitical risks both domestically and abroad have fueled uncertainty in global markets including:
- Limited details of the incoming Trump administration’s pro-business policies and focus on infrastructure spending.
- The trigger of Article 50 of the Treaty of Lisbon, which will kick-off official Brexit negotiations at the end of March.
- The French presidential election in April, which will weigh on the future of the Euro and its EU member states, particularly if the far-right and pro-independence (from the EU) candidate, Marine Le Pen wins.
Solution: As volatility increases so do option prices. Interest rate cap corridors and collars are a way to monetize optionality. A corridor includes the purchase of a cap at a lower strike while simultaneously selling a cap at a higher strike, allowing the investor to partly pay for the cap through the sale. A collar is the simultaneous purchase of a cap and sale of a floor with a lower strike.
Theme #4: Stronger U.S. Dollar
- A tightening U.S. monetary policy coupled with Trump’s fiscal plans that include potential corporate tax cuts will drive a stronger USD.
- As European Central Bank and Bank of Japan continue to have looser monetary policies, the USD will likely rally against the euro and yen.
- A burgeoning middle class in certain emerging markets such as Brazil may soften the impact of a stronger USD in those markets.
- As trade tensions continue with China, downward pressure will remain on the yuan.
Solution: Consider minimizing developed non-USD exposure via currency forwards or medium-term currency options.
To see how you may benefit from these macroeconomic themes, reach out to your BMA partner.
