Profiting From Rising Interest Rates: The Case For Long HEDJ Between 2017-2020

| About: WisdomTree Europe (HEDJ)

Summary

Follow up on my article from 2015 which argued rising domestic interest rates would help HEDJ investors, it appears the thesis is finally coming to fruition.

Savvy macro aware funds are poised to take advantage of differences in central bank policy between the ECB and the Fed.

Why the rise of domestic protectionism could be an ingredient in the recent dollar rally.

The carry trade and why the dollar rally seems poised to continue.

Why overweighting mid-caps may be the right choice in a Trump administration.

This is a follow up to my first article published here on Seeking Alpha.

On May 15, 2015, I outlined why HEDJ investors could benefit from the Federal Reserve raising interest rates. I described that, higher interest rates in the United States benefit investors in the WisdomTree Europe Hedged Equity ETF (NYSEARCA:HEDJ) by enabling them to earn an additional yield (know as "carry") atop of the dividend payments they already receive. In layman's terms, if the interest rates in Europe are 0% and are 1% in the United States, HEDJ investors will receive an additional 1% yearly on their investments. Of course, there are intricacies to the trade and you can't expect a 1:1 return on interest rate differentials due to investment costs and tracking errors. But simply put, the greater that interest rates in the United States are than in Europe, the better the returns should be (in theory, more on that later) for HEDJ investors. The Federal Reserve has been tepid in raising rates. But now, a year and a half later I believe that my original thesis is finally beginning to play out.

How Are Big Money Funds Positioning For A Stronger Dollar?

Recently I stumbled upon an article which outlined an interview of Seth Masters, who is the chief overseer at an $80Bn fund. He took criticism for predicting DOW 20,000 by 2018 back in 2012. I find when formulating Macro investment strategies, it's worthwhile to work on understanding the current mentality of institutional money managers as they always have the most votes when it comes to moving markets. He stated:

[sic] When you have stronger equity returns outside the U.S., but possibly weaker currencies, you need to have pretty nuanced strategies to take advantage of that.

By "nuanced" strategies, Seth Masters seems to be optimistic on strategies which are very similar or equivalent to HEDJ, which buys foreign European stocks but insures against a decline in the foreign stocks' currency denomination. Indeed, the dollar index has been rising which makes it difficult or impossible for U.S. investors to get returns on foreign currency stock holdings, even if foreign stocks are outperforming U.S. equity markets.

The above chart is a comparison between the performance of HEDJ versus SPY over the past year. The small vertical line is December 14th, where the Federal Reserve hiked interest rates for only the second time in a decade.

HEDJ Holds A Hedged Index of Exporter Stocks

HEDJ is designed specifically to profit from a weakening Euro. It holds equities in companies which derive at least 50% of their revenues outside of Europe and pay dividends. As these companies are traded in Euros but derive substantial earnings abroad, a decrease in the value of the Euro against other currencies will generally result in a rising share price as their earnings are converted into weaker Euros.

The fund goes short an amount of Euro foreword contracts equivalent to the fund's total value of Euro stock holdings, which offsets gains and declines in the Euro. It's essentially like owning a basket of European exporter stocks that are priced in U.S. dollars instead of Euros.

Two Probable Fed Hikes In 2017 Mean A Stronger Dollar

Traders are pricing in two rate hikes in 2017. That's from analyzing Fed Fund futures data, which is a strong indicator of the Fed's policy decisions. The current Fed interest rate is a range between 0.5 - 0.75%. Markets are expecting two hikes raising it up to 1.4% by year end. The ECB by contrast has a current interest rate of -0.40 - 0.0%.

Accordingly, the minimum "carry" an investor will earn by being short the Euro against the USD yearly is currently 1/2 a percent, or 0.5%. That's simply the differential between the interest rates of the two countries at the extreme ends of the range (0% for ECB and 0.5% for the FED). These earnings are gross, not net and brokerage fees will need to be subtracted.

Trump's Win Means a Stronger Dollar

Trump's stated trade policy of protectionism makes it less likely that the United States will continue to export an unchecked steady stream of dollars abroad in the future. The United State's imbalance of trade floods the world with dollars via it's trading partners and saddles it with debt. Trade deficits have been the status quo for generations, and has not resulted in calamity yet, in large part due to the dollar bearing the luxury of being the world's reserve currency.

Last year's trade deficit of 666Bn dollars has not gone unnoticed by the President elect and his future administration. The President elect seems to view the trade deficit as a pillaging of the country by foreign nations with unfair trade practices. Of course, changes will not happen overnight as many large corporations in particular depend heavily upon foreign trading partners and form a sizeable political clout. Decades of free trade will not be reversed but so much as curtailed, and since the markets operate heavily upon future expectations that still matters a whole lot.

The Twilight Zone of Economics: The Foreword Premium Anomaly - And How It Could Benefit HEDJ Investors

Here's where things start to get a little unexplained..

The Foreward Premium Anomaly describes how higher yielding domestic currencies, have historically appreciated against lower yielding foreign currencies. It's perhaps the strangest phenomenon in economics, because it makes a mockery of the "there is no free lunch," first rule of ECON 101. If you know of a stranger phenomenon in economics, please comment below!

Take for example our market participant who sells the EUR/USD "pair". They are long the USD, and short the EUR. Since the USD has a higher interest rate than the EUR currency currently, the person on the opposite side of the trade, will have to pay them a nightly a rollover fee of at least 0.5% annualized as we calculated above. It's a zero sum game, and this money comes directly from one market participant digitally transferred into the account of another.

Now why on Earth would the person short the higher yielding USD, on the opposite side of the trade want to pay a nightly rollover fee AND likely lose even more money as the lower yielding EUR (with a strong statistical probability) loses value!? I can't answer it, but perhaps some future Nobel prize winner in economics will.

If you're curious as to why rollover must occur, my first HEDJ article has a full explanation in layman's terms.

That's the foreword premium anomaly in a nutshell. Investors may exploit this phenomenon by diversifying across many currencies (using derivatives) in what is known as the carry trade. The carry trade is generally thought to earn investors between 4 - 5% per year (.pdf link) without the use of leverage. HEDJ investors are long the higher yielding USD and short the lower yielding EUR, so they should benefit from the Foreword Premium Anomaly in theory.

Exploiting the carry trade between currencies with small interest rate differentials such as the EUR/USD also bears higher risk adjusted returns according to academic research, due to the risk of an adverse currency crash (e.g. the higher yielding currency depreciating) being lower.

Now it's important to note here, there are two distinct carry trades ongoing in the digitized and globalized world of modern finance. One is conducted electronically through the usage of derivatives such as the one HEDJ investors exploit, and another is conducted by borrowing currency from one country and depositing it in assets in another country for a higher interest rate. The amount of money at stake in the carry trades of both types is extremely large.

Unwinding of carry trades can result in shock to economies. A rise in U.S. interest rates could trigger a global unwinding of massive carry trades both in both digital and real assets across many other nations as the dollar strengthens. While savvy macro investors profit from exploiting carry trades, it's worth remembering they are an ever present potent and uncontrollable force for financial instability with our system of floating currencies. They cannot be tamed even by central banks.

Europe - Zero Percent Rates Until 2020?

Imagine the world of finance in 2018, where the United States has an interest rate of ~2.1% (as expected) and Europe is still stuck at 0%. It's know as the zero lower bound trap. The ECB is expected to keep rates at zero all the way until 2020.

If Goldman's forecast for 2% growth in U.S. GDP over this year pans out, there will be very little justification for the Fed not to continue raising rates.

The current yield of HEDJ is 2.73%. HEDJ investors would "earn carry" on the 2.1% differential, giving the fund a gross effective yield of 4.83% by 2018 assuming dividends and share prices stay the same. Importantly, that is not to say HEDJ will earn a dividend of 4.83%. But the 2.1% gross carry earnings will be an additional source of income that the trustees of HEDJ could disburse or simply let pile up increasing the NAV of the fund. That's why I term it "effective" and "gross;" it's before expenses, tracking error and may not be disbursed directly.

If this scenario plays out, you can expect European dividend stocks to become more coveted assets internationally. I would expect a strong performance of the European exporter stocks in local currency terms. The Euro may very well go down precipitously, especially if it breaches the psychologically important 1:1 parity level. Instruments such as HEDJ and strategies similar to it could become a very crowded trade on Wall Street. There are only so many worthwhile beta-generating strategies for fund managers to allocate to in a world of capital superabundance.

Since HEDJ investors are "neutralized" against currency fluctuations, a strong performance in European stocks would benefit them no matter whether the Euro appreciates, depreciates or stays the same.

Macro Investing: What About Domestic Equities and Bonds?

A strong dollar is bad news for large multinational company earnings. Blue chips are the largest exporters and a strong dollar will hurt their earnings abroad. Mid-caps, which are more exposed to the domestic economy and export far less in terms of their revenue may be a fruitful area for macro-oriented fund managers to overweight in the coming years. I prefer mid-caps to small-caps, as mid-caps tend to be less volatile. They are also generally better run and have better access to capital which will start to matter more in a rising interest environment.

A significant differential between U.S. and European interest rates will create a stronger likelihood for financial shock and volatility. An increase in interest rates domestically may reveal asset bubbles which have been bubbling under the surface for years unnoticed. However, if the Fed does not raise interest rates they will have little "ammunition" (e.g. ability to cut interest rates in the future) for when the next financial crunch or crisis invariably happens.

Nonetheless, higher interest rates domestically are bad news for equities and bonds in general. HEDJ investors don't have to worry as much about rising interest rates, as Europe is believed to be far behind the U.S. in raising interest rates. Nonetheless, a shock hike by the ECB however unlikely is a risk HEDJ investors must bear.

Profiting From Rising Interest Rates

HEDJ is an extremely unusual financial product in that long holders of it should benefit from rising interest rates in the United States. Most typically, to profit from rising interest rates domestically one would need to short bonds in anticipation of their value falling. There are several problems inherent in shorting any asset including bonds, primarily the fact one would need to pay the coupon payments for the duration of the trade. The cost of carry (e.g. the cost of holding the asset) would be negative, not positive like it is with HEDJ.

In summary, the methods to profit from rising domestic interest rates for U.S. investors are few and far between. They also resemble trades, not investments. Even famously non-correlated alternatives such as Gold (NYSEARCA:GLD), are generally thought to become less attractive as interest rates rise. That's because the opportunity cost of holding Gold becomes greater the higher that interest rates are, and Gold has no yield. Theory and reality are two different things however, as there is some statistical evidence that Gold does well in rising rate environments.

Real estate is another alternative asset which is also famously interest rate sensitive, in that it becomes less affordable the higher interest rates are. That places general downward pressure on real estate values in a rising interest rate environment.

One Last Note About HEDJ

I'll leave the geopolitical analysis of the Eurozone to other authors who can do a much more competent analysis than myself. However, geopolitical risks remain, and could negatively impact the European equities in HEDJ. The prime risk HEDJ investors bear in my estimation is the market risk of the companies held by the fund, and the associated adverse geopolitical and economic factors which could result in share price declines in nominal Euro terms.

Conclusions

The Federal Reserve is stuck in a corner. It must raise interest rates, or it will not be able to fight the next financial crisis effectively and risk overheating markets. Inflation is not high but not negligible, and employment numbers look good enough for a rake hike.

It's said that Wall Street is not geared towards solving problems, but rather profiting from them. The problems of international finance and competing national interests present opportunities for savvy macro investors to take advantage of. The fact HEDJ has fallen out of favor in 2016 and experienced strong outflows makes it not necessarily an unattractive fund, but simply an overlooked fund.

While presumed to be accurate, the content of this article encompasses broad topics and may contain inaccuracies. It contains statements of opinion and should not be taken for a solicitation to buy or sell any security.

Disclosure: I am/we are long WETF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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