Calm Markets – Time To Hedge?

Warning lights in a quiet market

There are a couple of warning signals that we shouldn’t ignore. First, the recent failures of Tricolor Holdings and First Brands raise questions about whether other issues might yet surface. That was then followed by news that Zions Bancorp and Western Alliance Bancorp said they were exposed to alleged fraud, triggering a sharp sell-off in their share prices and weighed heavily on broader financial stocks. Sentiment has since recovered, but the price action suggests markets are nervous.

Secondly, the rally in gold. Traditionally sought after for its safe-haven appeal and as a hedge against inflation, the precious metal has more than doubled in value since the beginning of 2024. Many analysts argue the move reflects a world awash with liquidity, hence both global equities and gold rallying in tandem. However, it could also signal concern about persistent price pressures and the destabilising of fiat currencies.

Finally, derivative markets are starting to show signs of stress. The VIX index (often described as the market’s fear index) spiked last week to its highest level since April. Granted, it’s a long way from the dizzying heights reached in April post Liberation Day, but a jump in option volatility is reminder that the market remains on tenterhooks.

Hedge while vol is low

Fortunately for our clients, FX and IR volatility remains low and, hence, hedging these risks remains worthy of consideration. In practice, very few clients use options to hedge FX risk, but volatility is still a factor in determining credit charges, particularly for longer tenors. Euro-denominated vehicles hedging dollar assets also benefit from a significant narrowing of the interest rate differential between EUR and USD over the past three months (-228bps in July vs -166bps today when using a 1 year forward). Given the uncertainty surrounding US politics, this feels attractive, even if EURUSD spot is considerably higher than it was at the start of the year.

On the rates side, the market is still pricing additional cuts from both the Fed and, to a lesser extent, the BoE. While the ECB are less likely to cut further, there is little scope for it to start hiking again before H2 2027. As a result, we’re seeing clients lock in the current curves using swaps, or take advantage of relatively cheap caps given low volatility and inverted curves at the short end.

The quiet is the time to act

The point here isn’t to suggest that we’re about to see a big sell-off in risk assets, or even that heightened volatility is inevitable in the months ahead. Instead, the message is that when markets are calm, volatility is low and risks appear suppressed, it’s exactly the right time to think about taking risk off the table as the cost of doing so is relatively cheap.

As always, please reach out to your regular Validus contact if you would like to discuss specific exposures in more detail.