Currency hedging now a risk – Intech report

While Australian investors have benefited from currency hedging over the past five years, this cannot continue indefinitely. Now may be a good time to reduce currency hedging over international shares, according to a report by Intech Investment Consultants.

The report, sent to clients yesterday, says: “Australian investors should expect much lower returns from currency hedging than those of the past five years, especially for international shares. “For international bonds, we continue to favour full currency hedging because it dramatically reduces volatility. Currency hedging is still likely to have a positive impact on returns, even after interest rates increase to ‘normal’ levels in Japan and continental Europe. “For international shares, now may be the time for opportunistic investors to reduce their currency hedging. Currency hedging may have a negative impact on returns over short-term periods and may not necessarily dampen volatility.” Intech says that Australian returns from currency hedging depends on how qui8ckly interest rates return to more normal levels in Japan and continental Europe and whether the Australian economy can avoid an economic downturn. Australia has had one of its strongest and longest periods of economic growth in both absolute and relative terms, but no economy can escape the ups and downs of business cycles indefinitely. If the economy does turn down significantly, interest rates could be reduced by 2 percentage points from their cyclical peak, Intech says. The Reserve Bank reduced rates by 2.75 percentage points from their peak in 1996-98 and again by 2 percentage points in 2001. On both occasions the economy faced external shocks and the rate reductions helped avoid recession. But since then, the level of household debt has increased to the point that deflation poses a more serious threat than it did five years ago, the report says. A 2 percentage point reduction in Australian rates would leave them lower than the US and result in negative results from currency hedging. The last time hedging delivered negative returns was in 1998-99. Recent indications from both Japan and continental Europe are that interest rates are likely to return to more normal levels as the respective economies continue to improve. Intech believes that interest rates in Japan could increase by 2 percentage points and still leave the economy as o9ne of the most stimulative in the world. In Europe, bond markets are pricing in a 1 percentage point rise in interest rates over the next 12 months and a further 0.5 percentage point rise over four years.