Hedge Against Stagflation: How to FX Hedge for GBP Stagflation
Aug 20, 2022
Stagflation (a portmanteau of stagnation and inflation) occurs when the economy experiences both inflation and recession simultaneously. This is generally seen as a major economic anomaly because it goes against Keynesian economic theory, which states that the economy naturally goes through phases of inflation and recession separately.
This can be difficult for a country to manage because economic policy choices are limited. For example, if the government tries to stimulate growth through spending, this can cause inflation to rise even further.
Today, a nation’s currency is suffering from such an economic anomaly. In recent economic news, the Great British Pound (BGP) looks quite undervalued and oversold, according to Crédit Agricole. While a negative situation, it presents a good opportunity to buy the currency at a discount.
The British pound is a good investment if you think that prices will rise in the future (stagflation), but it is currently undervalued and not a good choice if you are looking for short-term investment and FX hedging against currency risk.
In other words, if the UK does not provide significant economic support, it could fall into a recession. This would make the British pound less attractive than other currencies and increase risk aversion.
The government's plans for the next year's parliamentary session have left investors concerned that the economy could enter a recession without proper fiscal support. Recent reports suggest that Prime Minister Boris Johnson will announce new legislation Friday, allowing his government to bypass portions of the Northern Ireland protocol.
Based on our latest updates, we think the currency is currently undervalued.
At This Very Moment, the GBP Is the Globe’s Sick Man Currency
This is because the pound is currently very volatile and is expected to continue to be volatile in the future. This makes it a good currency to sell, as you can make money from the fluctuations.
The British currency has become very popular among investors trying to express a negative view of the world's fifth-biggest economy. The economy faces many problems, such as slow growth and high inflation.
According to official data, inflation in Britain hit a 40-year high in April, while a Reuters article in May found that the country's worst cost of living crisis in three decades is not expected to subside until late this year.
The Bank of England (BoE) was the first major central bank to raise interest rates in December, but now its predicted future path is much less steep than some of its global peers, including the U.S. Federal Reserve.
The Brexit vote has left the British economy in a unique and uncertain position. Other factors, such as high government debt levels and low productivity growth, weigh on the pound.
The UK could face a messy trade conflict with the European Union if it pushes ahead with a law to override parts of a post-Brexit trade deal for Northern Ireland, which could disrupt trade and cause economic chaos.
A trade war would negatively impact the economy by widening the current account deficit and weakening the currency.
This means that the government is asking people for more money in taxes after giving them financial help during the pandemic. This is making it hard for people already struggling with high energy bills.
There is a high chance that the UK will shortly experience a recession due to the numerous challenges the economy is currently facing. This is according to Wouter Sturkenboom, who oversees investment strategies for Northern Trust Asset Management in Europe and Asia.
The difference between the interest rates that the Federal Reserve and the European Central Bank (ECB) are expected to inflate over the next year is only 12 basis points, with the Fed expected to raise rates by nearly two full percentage points and the ECB expected to raise rates by 108 basis points.
In recent weeks, markets have decreased their expectations for a UK interest rate hike because of the increased risks of a recession. A Reuters poll showed that 35 percent of respondents think a recession is probable within a year.
This means that the outlook of the currency's value is bleak; it will decrease.
The pound is not expected to perform well compared to other major currencies because the central bank does not intend to increase interest rates much, meaning it will have lower returns when accounting for inflation.
The war in Ukraine has increased prices, making UK people think the economy will worsen. People are also worried about how long the COVID lockdown will last in China, one of the UK's biggest trading partners.
Citibank's economic data indexes are lower for Britain than for the rest of Europe or the United States, suggesting that there are more economic challenges ahead for Britain than for other parts of the world.
It Gets Worse
The above data suggests that the current interest rate cycle in the UK will not last very long. According to HSBC strategists, rates will peak in June 2023 and then fall again. Income levels are falling, making it difficult for the BoE to keep interest rates low.
HSBC is now predicting that the pound will end the year at $1.20, which is 8 percent weaker than its earlier $1.30 forecast. The GBP has weakened against the USD since the beginning of 2022 and hit a new low a week ago.
The value of the British pound has declined rapidly in recent months as concerns about the UK's economic prospects have grown. The pound is now worth less than it was at the start of the year, and its value continues to fall. This knock-on effect on the wider economy as the cost of imported goods rises and inflation starts to pick up. The UK is facing the prospect of stagflation, where economic growth is sluggish, and inflation is high. This is a major concern for the global economy, as the UK is a major trading partner.
FX hedging has been drastically shifted on the currency market and is now betting against the pound more than they have in years. This shift comes after a period of betting against the dollar and in favour of the pound.
The situation looks bad and is not expected to improve soon. This is based on the fact that the number of people wanting to sell pounds (known as risk reversals) is at its highest in a month and that the pound price is expected to fluctuate intermittently in the next two years (as measured by the expected price swings).
Now Is the Time to FX Hedge Your Bets
Europe is facing high inflation and negative growth due to the ECB’s quantitative easing program, which has increased the money supply. This has caused prices to increase and growth to slow.
This market call suggests that the global energy crisis and central banks could cause key economies to enter a stagflation state like in the 1970s.
Some people are worried that there might eventually be a market scenario where inflation is out of control and growth is slowing down, especially in Europe.
According to the Bank of America Corp (BoA) fund manager survey, global growth optimism has sunk to an all-time low. Stagflation expectations have jumped to 66 percent, the highest since 2008. U.S. prices rose in March since late 1981, while additional data from Wednesday showed that U.K. inflation exceeded economists' estimates for the sixth month.
Europeans are becoming more pessimistic about the economy, in contrast to earlier hopes that the continent would do better than the United States. As a result, financial managers are taking steps to protect against possible bad economic news, such as investing in the US dollar rather than the euro.
Other popular trades include bets on commodity exporters from Australia to Canada and against bonds at risk of interest rate changes.
For stagflation to occur, many negative events would need to happen. Christine Lagarde does not believe that this is likely to occur. The ECB will have a meeting to discuss its plans for the future.
Inflation can be difficult for new traders to understand, especially with little experience. If prices rise rapidly, it can be hard to know what to do.
Stagflation-like pressures may not be limited to Europe. Still, if they are present there, they can negatively affect Wall Street traders who are banking on international growth. These pressures can also cause people to remember the sovereign debt crisis and the ten years of lost growth.
The region around Russia is a major concern for many, given its proximity to Russia's current conflict and its weaker economy. This year, German debt prices (an indicator of expected inflation over the next decade) have risen by over one percentage point. Additionally, prices paid to American producers have increased significantly in the past year.
How Can You Apply FX Hedges to Protect against Currency Risks?
There is no easy response since it depends on several factors, such as your team's overall hedging strategy, the degree of market volatility and the specific currencies involved. Ultimately, it is up to the treasury team to determine how to adjust their hedging program best to protect their company's exposure to currency risk.
In other words, should a company that typically hedges its currency risk adjust its strategy during periods of sustained currency movements? We explain the answer in three helpful ways:
The current strength of the USD has significantly impacted corporations whose revenues come primarily from foreign sources. These companies have seen their margins erode as their expenses and revenues have decreased. If the Federal Reserve raises interest rates, the dollar's value will likely increase, further exacerbating the problem.
A trend like this could cause treasury practitioners to re-evaluate their hedging strategies.
The next approach is to consider how the company’s business model might be impacted by a sustained change in the USD’s value. A stronger USD can be a headwind for companies that sell internationally, making their products more expensive for foreign buyers and potentially leading to lower sales.
Conversely, a weaker dollar can make a company’s products more competitive and lead to higher sales. Considering how a sustained move in the USD might impact the company’s costs is also important.
For example, a company that sources parts or raw materials internationally may see its costs rise if the USD strengthens. In contrast, a company with primarily USD-denominated costs may see its costs fall if the USD weakens.
Finally, it’s important to consider how the company’s hedging strategy might need to change in the event of a sustained move in the USD. Suppose the company is currently hedged and the USD moves in a direction unfavourable to the company’s hedges. In that case, the company may need to adjust its hedges to avoid incurring significant losses.
Conversely, suppose the company is not currently hedged, and the USD moves in a direction that is favourable to the company. In that case, the company may wish to consider hedging at least a portion of its exposure to protect against potential losses in the future.
To determine how a market trend will affect a company, one must first understand how the company's unique exposure profile relates to the trend. For example, if a company has USD expenses primarily and primarily CAD revenues, they may not be concerned about broad dollar strength. It is crucial to understand the nuances of the market, paying attention to bearish and bullish movements.
If the treasury finds that the current hedging strategy has led to unfavourable results, they should look at the program. If hedging a high percentage of exposures far into the future, they may have already lowered the overall risk.
They should compare the program results to what would have happened if they hadn't hedged to see how effective the approaches have been and make sure that people's expectations are realistic.
If an organisation's hedging ratios are low, there are some things they can do to change that. For example, they could adjust the exposure types, the prices they pay, or the ratios they use.