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As investors we have been living in a low inflation, low interest rate environment for a very long time. The concerted actions of central banks around the world have helped to keep bond yields low. But it now looks as if the global economy is finally picking up steam and with it will come the prospect of higher inflation and rising interest rates in many quarters.

Professional fund managers in the US feel that the market is continuing to underestimate the determination of the Federal Reserve to raise rates further in coming months.

According to one major hedge fund manager we spoke to this week, who spoke with us on condition of anonymity:

“For some reason markets are very, very reluctant to price in further hikes…though I think the Fed has made quite a shift. We’re used  to the Fed being a doveish institution, whereas I think they have shifted to a much more hawkish stance and are in the middle of a tightening program.”

He says he thinks the Fed plans to hike rates by 25 basis points, once a quarter, “provided they have the opportunity to do so.”

He also predicts an aggressive tightening program of three or four hikes this year, followed by a similar number next year:

“There’s a sort of received wisdom that there’s a lot priced in for the Fed, but it’s really not the case. [The market] has got about one-and-a-half hikes priced in for this year, and about one-and-a-half hikes for next year, and that’s really not very much at all.”

Even with the Fed’s hike in March, there was little expectation priced into the market until about two weeks before it happened. With the abandonment of a legislative wrangle over healthcare reform, there’s now also scope for Congress to concentrate on tax reform. The reduction of taxes in the US could provide  yet further boost to the economy, necessitating quicker action on rates by the Fed. Let’s not mention the fact that US unemployment is now down at where it was in the 1990s, when US rates were around 5%.

Where to invest?

As US rates climb, the USD could well end up being one of the higher yielding currencies out there. This means that holding assets in USD could pay better rates than other currencies. Based on a three month rate, the USD have moved from a number 10 ranking in 2012 to number three now. In addition, other countries are behind the Fed in terms of their own rate normalisation.

Let’s take Japan: negative rates at the front end of the yield curve, and virtually zero rates on the Japanese 10 year bond. The Bank of Japan has committed to keep rates low until it can get inflation under control. This means the JPY will likely end up being an attractive funding currency (the borrowed currency in a carry trade), and will fall against both GBP and EUR.

Look also for some real growth in Europe, which has been all bad news for far too long. Not only has economic growth been picking up, but it has surpassed US growth recently for the first time in a very long time. Obviously all eyes remain fixed on the French election, but those who have invested time and money in assessing a likely Le Pen victory say it is very unlikely. French assets in particularly have been heavily sold recently, and a win for Macron will see a considerable medium term rally. As soon as some of the political risk comes off the table, look for rallies in the EUR market, in French equities and heck, even European banks. Possible other trades include short European government debt.

Where now for the EUR?

The market is still short the EUR for the most part. Funds flow analysis being performed by some of the bigger hedge funds on the block is noting a significant chance that the European Central Bank will raise rates before the end of this year, possibly in September or December. The ECB is also trimming down its asset purchase program, from €80bn to €60bn. This is likely to be cut further with scope for it to be abandoned altogether in 2018.

One possible trade that investors might want to look at is the so-called equity risk premium trade – going long equities while at the same time shorting government bonds. Using a CFD trading account, it would be possible to run these two trades at the same time, and it could be a consistent earner in the second half of this year, if not earlier. Many brokers quote prices on the main German debt markets for example, as well as the big European stock indices.

What is a carry trade?

We mentioned the carry trade previously, but what is it? A carry trade involves borrowing in a currency where rates look set to remain low – for example JPY. This is used to then invest in a currency that has much higher rates. Recently this has been resource currencies like AUD and CAD, but with rates picking up in the US, we could see more investors borrowing yen to buy dollars. Carry trades involve trading physical currencies, rather than trading forex pairs.

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Please note this article does not constitute investment advice. Investors are encouraged to do their own research beforehand or consult a professional advisor.

Stuart Fieldhouse

Stuart Fieldhouse

Stuart Fieldhouse has spent 25 years in journalism and marketing, including as a wealth management editor for the Financial Times group, covering capital markets and international private banking, and as an investment banking correspondent for Euromoney in Hong Kong. He was the founder editor of The Hedge Fund Journal.

Stuart has worked at CMC Markets, supporting the re-launch of its global financial spread betting and CFD trading platforms. He is also the author of two books on trading, published by Financial Times Pearson. Based in The Armchair Trader’s London office, Stuart continues to advise fund managers, private banks, family offices and other financial institutions.

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