Establishing a risk policy framework

By late October of this year, election polls were predicting a landslide victory for Democrats in the 2020 elections, with the “blue wave” narrative gaining momentum. The Treasury market responded with an increase in the 10-year rate from a low of 0.77% up to a high of 0.90% on November 3. This reflected increasing expectations of a fiscal stimulus package and, in turn, higher growth and inflation expectations.

By election night, the early reported results trended toward a Trump victory with a Democratic House and a Republican Senate. Bonds rallied with the 10-year Treasury yield falling back to 0.76%. In the foreign currency markets, the yuan also sold-off sharply as fears of a tougher U.S. trade policy struck the Chinese currency. As the count continued, the numbers swung the other way, with a Biden victory predicted; the yuan sell-off flipped to a rally. Treasury yields also reversed course and started to increase on November 5 as the Biden lead grew (although still with a Democratic House and Republican Senate for now).

On November 9, markets received another shot in the arm with positive news on the Pfizer coronavirus vaccine. Treasury rates increased again, and the stock market saw a strong rotation from high-flying tech stocks into the beaten-down sectors such as small caps, real estate, banks, and airlines. While there is still uncertainty on election results due to the Georgia Senate runoff elections and potential presidential vote recounts, the market drivers over the past week have shifted from pure politics-driven toward pricing in a full re-opening of the global economy.

Going forward, can we predict which factors will drive short-term moves in interest rates? Will another U.S. wave of COVID-19 over the winter overshadow the recent vaccine news? Will there be difficulties in rolling out a vaccine that reduce forward growth and inflation expectations and cause rates to decrease? The Pfizer vaccine needs to be shipped and stored at extremely cold temperatures (-70˚ C) — will this result in wealthier nations getting vaccinated first and lead developed market currencies to outperform emerging market currencies? If Democrats win the Georgia Senate runoff elections, a 50–50 Senate gives the vice president the tiebreaker vote. Even with the current runup in Treasury yields, is the market correctly pricing in a $3 trillion stimulus package (like the one the House passed this May), potentially becoming a reality early next year?

There are many iterations of potential outcomes in the world, and markets are constantly pricing in their best estimate of the future which is constantly changing. There are plenty of “known unknowns” being absorbed by the market at any given time — new macroeconomic data, elections, Federal Reserve meetings, political dynamics, and plenty more. Exogenous shocks (“unknown unknowns”) also come into play, surprising markets and resulting in volatility while a “new reality” is priced in. The Swiss National Bank abruptly abandoning its Euro peg in 2015, Brexit in 2016, the Federal Reserve declaring “we’re a long way from neutral” in the rate hike cycle ending in late 2018, and the current COVID-19 pandemic all created periods of volatility as the markets adjusted to a new normal.

In the absence of a crystal ball to predict the future, we are left in the position of analyzing what is currently priced into the market and estimating risks from there. There are enough “known unknowns” that it becomes impossible to fully predict the timing of these events, how they will play out, and the ultimate impact they will have on markets. The chart below shows LIBOR forward curves at points over time (gray lines) compared to the actual historical path of 1-month USD LIBOR (blue line). Every deviation between the gray lines and the blue line shows where the actual path of LIBOR deviated from what the market had priced in at a previous point in time. These are colloquially known as “hairy charts” — an apt description for anyone who is trying to manage risk exposures in these times.

Having a risk management policy framework removes the guesswork as to what markets will do. More importantly, it reduces human subjective judgement and allows you to focus on which risks you can tolerate and manage, and which you cannot. How do returns look against a range of interest rate scenarios, and in which scenarios does the impact on returns start to become more noticeable? Does it make more sense to lock in your exposure with a swap, focus only on worst-case scenario protection with an option product, or stay unhedged and allow the portfolio ride out any market fluctuations?

Here are some basic questions to answer when you draft a risk management policy framework:

• How much exposure do I have to interest rate/foreign exchange market risk?
• How would various market environments impact my returns, and how much of this risk am I willing to bear?
• What is the best way to systematically hedge the risk I do not want to take?
• How should I evaluate the effectiveness of this strategy and its impact on my investment objectives?
• How often should I be evaluating my framework?

This is not an exhaustive list by any means, but it gives a good starting point to create a methodical and valid risk management approach. Chatham can help you answer these questions to provide a strong frame of reference, evaluating where your market exposures lie, how to best think about these risks, and how to manage them. Chatham’s approach will incorporate market best practices while accommodating your unique risk tolerance.