It's still not too late

Economic vista: It's still not too late

Travis Dugan, CFA, Managing Director, Portfolio Management
Ivan Oscar Asensio, PhD, Head of FX Risk Advisory

Opportunities still exist for US-based companies as they relate to the management of cash, investments and foreign exchange (FX). All too often these areas have represented stiff headwinds for domestic corporations doing business abroad. But more recently, currency market trends, as well as a more measured Fed rate-cut campaign, have shifted the narrative and turned these headwinds into potential tailwinds. How long will these dynamics last, and what actions should forward-thinking organizations be considering?

Perhaps at the heart of this shifting environment has been a positive correlation between US interest rates and the US dollar (USD), which has provided a dual win for many companies. The Federal Reserve (the Fed) has made great progress on bringing down inflation, though they have stated some recent concerns about how quickly they might achieve their long-term inflation goals. The shift from extreme accommodation during the pandemic years to a much tighter policy to help fight inflation has naturally ushered in a period of higher (if more normal) interest rates. In turn, this has allowed companies to generate material income streams for the first time in well over a decade. Meanwhile, a strong USD has benefited companies that price goods and services in USD but have operating expenses in foreign currencies.

The windfall has been particularly beneficial for high-growth technology and life science companies, helping to ease their cash burn rates and offset the challenges presented by a tougher fundraising environment and higher cost of capital. For global public companies, there have been unexpected FX risk management benefits. Revaluation of foreign assets and liabilities (aka remeasurement) may be destabilizing to earnings if not addressed. Generally, the FX volatility created from such remeasurement activity can be remedied by implementing balance-sheet hedging programs, which deploy forward contracts to create synthetic offsets within current income. The new income streams from holding cash and short-term investments, which also run through current income, have worked to smooth earnings, serving as a natural hedge of FX remeasurement volatility.

Time to extend and hedge?

Looking ahead, however, this dual windfall may be turning into a dual headwind as the trajectory for both rates and FX has reversed. After raising the fed funds interest rate 11 times during the most aggressive rate-hike campaign on record in 2022/2023, the Fed cut rates 100 bps in its final three meetings in 2024. While the pace of rate cuts has slowed, there are one or two additional cuts now expected for 2025, which will be realized if additional progress is made on getting inflation closer to the Fed's long-term target of 2.0%.

Without the boost of higher interest rates and wider interest rate differentials, the USD will likely struggle to make new highs. Furthermore, the post-election USD bull drivers seem to be waning. Concerns of increased government spending, which would likely lead to higher yields and a stronger USD, appear to be subsiding due to early efforts by the Department of Government Efficiency (DOGE). Tariff anxiety, which reignited inflation expectations, is also cooling as tariff threats are perceived to be negotiation tools, not a basis for real policy. As always, it's an ever-evolving situation that bears scrutiny. But the reversal of those prior trends for the USD would erode the dual windfall enjoyed recently by domestic companies.

Develop an action plan

There's no arguing that money market fund yields remain attractive at rates around 4.30%. However, when the Federal Reserve reduces rates, money market fund yields are typically the most responsive. In other words, when the Fed cuts, money market yields will no doubt quickly adjust lower. That could be trouble for complacent investors that have overweight cash balances parked in money market funds.

But there's still time, and investors may be able to preserve today's attractive yields by extending the duration of their portfolios. For example, 1-year Treasuries yield around 4.35% at present value if market expectations for Fed rate reductions are realized. In addition, investors may be able to capture additional yield by investing in commercial paper, corporate bonds, and/or asset-backed securities, which are trading at yield spreads above Treasuries.

An additional benefit of extending the duration in a portfolio is that it reduces the amount of income that needs to be forecasted. We've pointed out that money market fund yields are likely to adjust lower quickly once the Fed begins reducing the policy rate. The timing and extent of those rate cuts can only be estimated, and recent history illustrates that the futures market is not always an accurate predictor. In addition, inflation and labor data can change—often surprising market pundits—and the Fed has repeatedly demonstrated that it is not afraid to be "data dependent" no matter what the market wants. On the other hand, 1-year Treasury and corporate bond yields are known at the time of purchase and thus can provide clarity and steady income until they mature. For many companies, this clarity may be more valuable than rolling the dice to capture an extra few basis points.

Although every situation is different, in general we would recommend taking an incremental approach to extending duration. For example, a barbell strategy can be used to maintain a buffer of cash to be invested in money market funds to meet near-term liquidity needs. Then, investors can redeploy the balance of the portfolio in 1- to 2-year bonds to lock-in yields for a longer duration. This strategy may preserve liquidity while also locking in attractive yields, and it represents one possible action plan to consider in the current environment.

Positioning for a weaker USD

Interest rates are one area of focus, but for many companies it's equally important not to neglect the currency markets. By a margin of three to one, SVB clients are net USD sellers as foreign operations, and growth tends to be funded by USDs raised domestically. So, what does this mean?

When interest rates were at the zero lower bound, most of these net sellers tended to deploy a strategy of pre-funding foreign currency accounts (e.g., buying currency on a spot basis) to protect against exchange rate volatility. This was a viable alternative to derivative hedging as the opportunity cost (of not holding USDs) was minimal. Today, however, deploying USDs to hedge currency risk forfeits the potential benefits of high yields earned in the US Locking in future currency prices via forward contracts delays the deployment of USDs, maximizing USD yields earned while insulating business results from currency volatility.

Firms with more sophisticated risk management goals (e.g., rate flexibility, upside potential, asymmetric payouts) may find attractive valuations for FX option hedges. Implied volatilities, the leading drivers of options prices, are still trading at cycle lows despite the potential market disruptions that may lie ahead (see chart, below). In fact, at the current level of interest rates and implied volatilities, the USD interest earned on one unit of cash for a 1-year period is now more than the cost of a 1-year option that hedges one unit of exposure for most developed economy currencies.

When used for risk management purposes, options offer two-way benefit protection if prices go against, and opportunity if prices go in favor. The value proposition is especially attractive due to current pricing dynamics.

Don't forgo the tailwinds

Although the dual benefits of higher interest rates and a stronger USD have finally been providing benefits for US companies, it's important to remember that the environment is dynamic. Things can and do change, often unexpectedly. That's why now may be an excellent time to consider the actions that can keep the interest rate and currency tailwinds in place.

Trading vista: Tuning out the noise

Jason Graveley, Senior Manager, Fixed Income Trading

While the January jobs report was "noisy," with a mix of weaker than expected headlines and a drop in the unemployment rate, it still indicates a still solid labor market. But is this a case of good news, bad news? Most will agree that low unemployment is one sign of a healthy economy, not to mention one-half of the Fed's dual mandate. But do these relatively tight labor conditions change the calculus regarding future rate cuts?

No doubt that the Fed will now shift its focus to the upcoming inflation data, where investors will look to see if prices resume their path toward the Fed’s 2% target. Regardless, markets have already curbed their go-forward expectations for interest rate projections. If we look back just two months, markets were pricing more than three cuts in 2025. Fast forward to today, and futures probabilities are showing just one cut for this year, which has largely been pushed into the third quarter.

Market technicals have remained consistent to start the year, as many had projected, with Treasury yields remaining range bound. It was largely anticipated that the incoming administration had real potential to be a catalyst for volatility, but even that has ebbed and flowed with announcements and delays regarding policy changes. Many of the moves from the new administration, largely those regarding immigration and trade, likely won't affect the economy until later in second quarter, and even then, it's unclear how much they might ultimately impact inflation. But when one tunes out all the noise, it seems likely that the Fed will remain on the sidelines at least until the second quarter when we may have more clarity.

The Treasury curve has remained flat through January, with only approximately 10 basis points of difference between the 1-year Treasury bill and the 5-year Treasury note, at the time of this writing. A flatter yield curve, relatively attractive yields, and a slower-than-expected rate cut cycle has left money market balances elevated in this environment. This was evidenced by the estimated $7 trillion parked in money market funds toward the end of 2024. However, while those yields are attractive today, the forward path for rates (and especially short-term rates) can change quickly. Investors that can take on duration have tactically put money to work in different parts of the curve, while moving more neutral toward benchmark duration. Market participants have projected the neutral rate—the rate at which monetary policy is neither stimulating nor restricting economic growth—to be around 3.5%. If that's the case, rates still have room to come down. And we all know that money market rates generally track the fed funds rate closely. How quickly and exactly how much those yields will drop continues to be up for debate. We'll be watching to see how the economic data shakes out, and we aim to position accounts with the right mix of yield potential and liquidity no matter the ultimate policy path.