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Summary

  • In a rising rate environment, even a well balanced portfolio of stocks and bonds may be detrimentally affected as both stocks and bonds will sell-off when interest rates rise.
  • The United States dollar performs well when interest rates rise in the United States.
  • Go long the United States dollar and short the euro to hedge a portfolio of stocks and bonds against the risk of rising interest rates and further Eurozone woes.

Last week, the Standard & Poor's 500 Index (NYSEARCA:SPY) had it's biggest weekly drop in two years. The S&P opened at 1,978.25 on Monday and closed at 1,925.15 for a weekly drop of 2.7%. Furthermore, U.S. Treasuries (NYSEARCA:TLT) also struggled as they fell in concert with U.S. equities.

Possible Reasons for the Decline in the S&P and Treasuries

There were many possible reasons for the decline in the S&P and Treasuries. Listed below are the more probable contributing reasons for last week's selloff in the S&P and Treasuries:

Possibility of higher U.S. interest rates - Positive U.S. data, including a higher than expected second quarter U.S. GDP growth of 4% and a nonfarm payroll report above 200,000 (albeit below expectations), stoked fears of the Federal Reserve tightening monetary policy sooner than expected. Both the equity markets and the bond markets sold off on news of an improving U.S. economy and rebounded on any indicators that fell short of market expectations.

Deterioration of the Eurozone economy - The risks from the Eurozone came from two sources:

  1. Further problems arising from Eurozone bank liabilities, specifically the Portuguese bank, Espirito Santo (OTC:ESFHF); and
  2. The continued slowdown in the Eurozone economy, including the possibility of deflation.

Continued conflict in Ukraine - The situation in the Ukraine deteriorated further with new sanctions imposed on Russia.

Conflicts in the Middle East - Two geopolitical risks in the Middles East weighed on the markets:

  1. Israel's deployment of armed forces in Gaza; and
  2. ISIS gaining ground in Iraqi government controlled territories and, to a lesser extent, Kurdish controlled territories in Iraq.

Rising Interest Rates Caused the Sell-off in Treasuries, and Contributed to the Sell-off in the S&P

Revisiting the four possible causes of the selloff, three of the possible causes (Eurozone woes, Ukraine conflict, and the Middle East conflicts) would have seen a selloff in equities, but a rise in Treasuries. Only the fear of interest rates rising would have caused both a selloff in the equity markets as well as in the Treasury markets. Thus, the cause of the market turmoil in the past week was, at least in part, due to expectations of the Federal Reserve tightening earlier than expected.

Hedging a Diversified U.S. Stock/Bond Portfolio when U.S. Interest Rates Rise using Forex

Traditionally, a portfolio consisting of stocks and bonds have been less volatile as the two asset classes usually move in inverse correlation. However this was not the case this past week as both stocks and bonds took a turn substantially lower. Even gold (NYSEARCA:GLD), a traditionally uncorrelated asset class, closed lower for the week. Famed bond investor, Bill Gross, remarked on the lack of a safe haven in the current markets.

We believe that in this current market, a portfolio of stocks and bonds can benefit from a long United State dollar position. However, we do not give a broad endorsement of the USD and thus cannot recommend the use of broad USD bull exchange traded funds (NYSEARCA:UUP). Instead we recommend a short EURUSD position to hedge the downside risks present in both the equity and bond allocations of a portfolio. A short position in the CurrencyShares Euro Trust ETF (FXE) would also suffice, but due to easily accessible leverage in forex, an investor would be able to hedge U.S. stock and bond exposures with only a small amount of funds relative to their portfolio when using forex instead of currency exchange traded funds.

While it may be easy to recommend a short EURUSD position in hindsight, we contend that EURUSD will continue to be a viable hedge for a portfolio consisting of stocks and bonds in the foreseeable future. Fears of a tighter U.S. monetary policy is unlikely to dissipate in the near future and will push the USD broadly higher when fears of interest rate hikes reemerge. Eurozone worries will also continue, whether it be fears of deflation, continued debt problems, or an escalation of tensions in Ukraine. Any Eurozone economic problems will be euro negative, while any tensions in Ukraine will result in a stronger USD and weaker EUR (likewise any geopolitical tensions in the Middle East would also result in a stronger USD and weaker EUR). Furthermore, a short EURUSD position would benefit from any quantitative easing engaged by the European Central Bank.

EURUSD has fallen significantly in the past few days and was at approximately 1.3420 when the currency markets opened in Asia. With news of Portugal's central bank taking control of Banco Espirito Santo SA over the weekend, the euro is likely to rebound in the short-term. However, in the intermediate-term, a short EURUSD position is an ideal hedge for an investment portfolio consisting of U.S. equities and bonds.

For those that wish to initiate a short EURUSD position, but are willing to wait for a better entry point, which I believe is more likely to materialize than not, EURUSD 1.3500 and EURUSD 1.3600 are targets that EURUSD may rebound to in the coming days where traders can initiate short positions.

Conclusion

It's often asked why someone should include forex into their investment portfolio. The past week highlights the use of forex to complement an investment portfolio. While both U.S. stocks and bonds fell victim to market turmoil this past week, a short EURUSD position placed to hedge U.S. stock and bond positions would have mitigated some losses that a portfolio may have incurred.

Source: How To Hedge A Diversified Stock/Bond Portfolio When Interest Rates Rise

Additional disclosure: I am long the S&P, long GLD, and short EURUSD for my personal account and my clients' accounts.