Everyone has been talking about inflation and interest rates and yield curve inversions lately, so what does it all mean?

While a lot has been written about the effects on the stock market when interest rates rise, what happens to commodity prices, consumer price inflation and currencies? What about the influence of higher interest rates on longer-term bond yields?

To set the stage, there have been nine periods of rising central bank rates in the U.S. since the late 1960s. They have typically lasted just over two years and increased on average five full percentage points.

However, subsequent to the dramatic rise during the late 1970s and early 1980s when Paul Volcker was head of the U.S. Federal Reserve, rate increases have averaged only around 2.75 per cent. Some of these periods were as short as a year with one lasting just over four years during the height of the inflationary period from 1977 to 1981.

We know the history of U.S. stocks during these periods of rising rates. Six months to a year after an initial rate increase, U.S. stocks have still moved up around five per cent. Furthermore, longer-term analysis shows that even during the last eight rate-rising cycles since 1970, which have typically lasted about 2-1/2 years, the broad-based U.S. stock market still moved up on average around seven per cent during those tightening phases.

• Crystal balls are especially wonky, so watch your news feed
• Land prices set a sizzling pace as buyers outnumber sellers
• Worsening global food security needs Ukraine, Russia production, UN chief says

Based on past trading patterns, rising interest rates may not be as much of a concern for stocks as you think.

Now what about other areas like commodities, inflation, currencies and long-term interest rates?

During these previous rounds of rate increases, U.S. consumer price index inflation registered at about five per cent. Considering inflation is currently running above that at around 6.5 per cent in Canada and 8.5 per cent in the U.S., we could match that historical average annual inflation rate of five per cent or even more over the next couple of years.

Likewise, commodity prices rose over 15 per cent on average over the course of these rate-rise periods, or just over six per cent annualized. Of note, commodities were up almost 100 per cent from 1972 to 1981, which was greatly influenced by the 1973 oil embargo and then the 1979 Iranian Revolution. Perhaps we’re seeing echoes of this today with the Russian invasion of Ukraine and resultant economic and trade sanctions that are constricting agriculture, energy and metal commodity supplies.

As for currencies, the U.S. Dollar Index (which compares the U.S. dollar to a basket of other global currencies), didn’t really show any particular trends either way — although it had swings of five or 10 per cent, both up and down. But this is nothing out of the ordinary compared to any random one-, two- or three-year period.

This is likewise true of the Canadian dollar versus the U.S. dollar.

There was not much change most of the time, moving five per cent or less, which isn’t significant movement for a currency over a two- to four-year period. However, the Canadian dollar did have a few bigger 15 per cent moves both up and down.

Overall, though, rising rates in the U.S. did not produce any specific directional trading activity for the U.S. dollar since there are just too many other outside factors that can influence the direction of global currencies.

Finally, what have longer-term rates done when short-term rates move higher?

In all previous instances, 10-year U.S. Treasury bond yields did increase and did so fairly consistently, moving up around 25 per cent by the end of the cycle. So if 10-year U.S. Treasury rates were around two per cent before the Fed started raising rates, a 25 per cent increase would bring it to 2.5 per cent. Since the yields are already almost three per cent, they could eventually reach three per cent, four per cent or maybe more, with similar levels in Canada.

Bottom line, the fluctuations of stocks, bonds, currencies and commodities during periods of rising interest rates are not always as dramatic as you might think.

The main exception was the high inflationary period from 1977 to 1981 which was certainly the most disruptive of all these time periods. Historically, commodity and stock market activity were the most consistent. Both these asset classes generally moved higher during interest rate hikes while currencies had big moves both up and down.

So how will history repeat itself this time around?

No one knows for sure but it will have its own unique characteristics. There are no rules when it comes to how various commodities, assets and currencies will react during each interest rate-rising cycle. So much will be determined by unknown and yet-to-occur political, military, economic, monetary, social and weather events.

As always, never say never and use all the grain-marketing tools available to you, especially option hedging strategies, to capture price opportunities, manage downside risk and minimize delivery concerns.

The post How widespread will interest rate fallout be? appeared first on Alberta Farmer Express.

Forward contracts are simple, but are they the most effective tool? It depends on whether now is a good time to lock in prices. With forwards, since you lock in at a fixed price without the potential for gain, there can be a lot of opportunity cost and you can leave a lot of money on the table.

There are other potentially more profitable risk-adjusted option strategies to consider instead of, or in addition to, just forwards. Provided is an example of a risk-management profile we implemented for a client showing why options can often offer a better risk-reward ratio than using only forwards.

Example

Last year at this time, we helped a client who needed to manage his Canadian dollar risk. To better understand their situation, we have included some of the criteria used to determine our best strategy for their needs:

• The client had sold grain in U.S. dollars with payment expected late summer/early fall.

• Given the C$ had moved higher from 1.00 par to 1.045 from March 2011 to April 2011, we wanted to leave some room in the event the C$ pulled back from its recent strong run but still have protection against a move higher.

• At the same time, the client was less concerned about the C$ going much above 1.10 U.S.

• Also, the client would be happy locking in C$ at a much lower level of 1.02.

• We wanted to structure the hedge so there would be little net cost to the client.

Option strategies

Option strategies work best considering all these conditions combined. In early April, with the C$/U.S. exchange rate at 1.0450, we recommended the following to hedge a US$800,000 payment expected in the summer/fall of 2011:

• Buy eight September 1.0500 calls for $16,400 for premium paid including commission and fees as protection against a stronger C$.

• Sell eight September 1.1000 calls for $3,200 for premium received including commission and fees to offset some of the cost of buying the 1.05 calls since the client was not too concerned about C$ moving above 1.10.

• Sell eight September 1.0200 puts for $11,400 for premium received including commission and fees to offset some of the cost of buying the 1.05 calls since the client would be happy to convert his US$ into C$ at 1.02.

• Therefore, it cost $1,800 to implement this $800,000 hedge until September.

In summary, this strategy provided protection from 1.05 all the way up to 1.10, with the opportunity to convert at a better rate if C$ dropped back to 1.02, all at little cost to the client.

Results

So, how did this strategy unfold? As you can see from the chart, the C$ moved sideways to lower in favour of the client. Based on US$800,000, the net benefit of the strategy was $17,320. The main gains came from having the flexibility of an option strategy to convert US$ into a weaker C$ at 1.02 rather than locking in the US$/C$ up at 1.045.

Here’s how the approximate numbers worked:

• The cash currency gain from converting cash US$ to C$ was of $32,720 since the C$/US$ spot rate fell from 1.0450 at the beginning of hedge to 1.0041 at end of hedge.

• The option hedge offset was $15,400, representing the difference between the put sold at 1.02 and the spot rate of 1.0041 as well as all option costs, commission and fees.

• The net gain from hedging with options versus just locking in a forward was therefore $17,320, assuming the client exchanged the cash the same day the hedge was lifted.

This is just one example and it won’t necessarily work this cleanly every time. For instance, if the C$ had moved dramatically lower, significant funds could be required during the course of the hedge to cover the short put until the US$800,000 account receivable was received and the hedge was lifted.

Regardless of the exact strategy you implement for your situation, we advocate a continuous, disciplined, proactive approach to put the odds in your favour over time. Remember, it’s too late to buy fire insurance when your house is already on fire; or, if you can, it will be extremely expensive and difficult to implement. Bottom line, as we like to say: “Manage your risks before they manage you!”

canadian dollar     u.s. dollar exchange

The post Hedging strategies if you’re selling grain in U.S. dollars appeared first on Alberta Farmer Express.