Central bank actions impacts FX-hedging activities with FX forwards

Since the last quarter of 2021 interest rate hikes have become mainstream in the world of central banks. In Europe some smaller central bank had already started raising their interest rates earlier. In Eastern Europe it was the Hungarian central bank that already on 23th of June 2021 chose to raise its policy rate from 0.60% to 0.90%. The Czech central bank followed  a day later with a hike of the main rate of 0.25% to 0.50%. As at January 2022 the rates of these central banks are 4.30% for the Hungarians and 3.75% for the Czech. In Western Europe the central bank of Norway (Norges Bank) was the first central bank to move. On 23th of September Norges Bank decided to raise the deposit rate from 0.00% to 0.25%. Closer to home, the Bank of England followed on 16th of December. The rate of the Bank of England was raised from 0.10% to 0.25%.

The most important central bank of the world, the US Federal Reserve, ended the year by saying that the Federal Fund rate would rise after the end of the QE-program, which is planned on 16 March 2022. At that time around 3 hikes were expected for 2022. After some inflation numbers which have not been seen since the 80-ties of the previous century (US December inflation amounted to 7% on an annual basis), the Federal Reserve seemed to become more determined in fighting inflation. After the Fed-meeting of 26 January 2022 chairman Powell even did not rule out a rate hike at each of the 7 remaining interest rate meetings for 2022.

The European Central Bank does currently not seem to be close to an interest rate hike. For 2022 the chance of a hike is very small according to the statement of ECB-chief Christine Lagarde. Till now the ECB holds on to its opinion that the current high inflation is transitory.

The change in central bank strategy regarding their policy rates has a direct influence on the short term interest rates. Traditionally the short term swap rates are very sensitive to the prospect of interest rate hikes or cuts. So it will not be a surprise that the Czech and Hungarian short term swap rates have risen significantly. The one year Hungarian swap for example rose from 1.02% in May to 5.32% actual. To a lesser extend the US and GB swaprates have also risen. On the contrary, the 1 year swaprate of the Eurozone was flat during most of 2021 and has only recently starting to improve a bit.

The current situation described above, is clearly visible in the FX-forward market when hedging foreign currency against the EUR by using a FX forward contract. The number of term pips (forward points) increased significantly when one of the higher yielding currencies is being hedged against the EUR. For example the number of forward pips for hedging USD against EUR amounted to 92 (0.0092) at the start of Q4. Due to increasing interest rate differentials between the US and the Eurozone, that has risen to 165 (0.0165) at the end of January 2022. This implies a rise of 79%. For hedging GBP against EUR the number of pips also increased significantly. The number of term pips on a 12 month hedge increased from 83 at the start of Q4 to currently 133 term pips, an increase of 60%.

The divergence between central bank interest rate policies have a significant influence on FX-hedging by using forwards. The current situation of slow ECB-action and faster action of other central banks, leads to a disadvantage for parties that sell the foreign currency in the future against the EUR. On the other hand, parties that want to buy the foreign currency in the future have an advantage. They get more foreign currency for each EUR because of the high number of forward points (apart from the development of the spot rate). This situation can hold until the interest rate policies of the central banks divergence at a lesser extent than currently. This is not expected to be the case very soon.

Haseena Khodadin (EY) & Harco Nijland (EY)