Inflation has become the leading concern for global citizens in 2022, and it is no surprise that investors, and asset owners, also share this concern. CNBC reports that the consumer price index, a key inflation barometer, increased 7.7% in October compared to a year ago. Experts predict this trend looks well set to continue for the next quarter too. With inflation soaring, what are the best strategies for fund managers going forward? Apparently, inflation hedging can be accomplished on multiple fronts by trading forex pairs. Read on!
There are still bright sides to the dark cloud of inflation, and forex trading could be the best hedge against inflation, given that it offers potential earnings even during economic downturns.
What is Hedging?
Hedging refers to the investment strategy that eliminates the possibility of losing on one investment by purchasing assets that perform in the opposite direction. Basically, it’s a technique for reducing the risk of adverse price movements.
The hedging technique, in practice, is applied almost everywhere in the trading and investing world today. Various corporations, portfolio managers, day traders, and individual investors use hedging techniques to reduce their exposure to potentially dangerous risks. Whatever the type of financial instrument or trading style you choose, having an understanding of inflation hedging strategies can significantly minimize the likelihood of you losing money on your trades.
What is an Inflation Hedge?
It is important to note that inflation reduces the value of financial assets and the returns earned on them. It is for this reason that traders and investors need to think about inflation hedging when making financial decisions. Investors who don’t have time to act but are too concerned about their investments losing value because of inflation are often on the lookout for inflation-hedging assets for their portfolios.
“Inflation Hedging plays a crucial role on the investors’ portfolio”
In its simplest terms, ‘Inflation hedging’ refers to an investment that protects an investor from the detrimental impacts of inflation.
Investing is largely about preserving the effective value of portfolios, which requires defensive strategies. Unfortunately, the purchasing power of existing assets cannot be protected with a magic wand. Therefore, when investors seek a ‘hedge against inflation’, they look for assets whose total returns are at least equal to or greater than inflation. The purpose of ‘inflation hedging’ is usually to add more of those assets to their overall portfolio and remove assets that will not provide adequate protection.
Typically, real estate and hard assets, like gold or silver, can be invested in ways to hedge against inflation. In spite of the fact that these assets may fluctuate in value at times, over time, they tend to retain their value, which gives investors some protection in times of inflation. Similarly, foreign currencies can also provide investors with a level of protection similar to that provided by these assets.
How important is it to hedge against inflation?
As long as inflation rates are below interest rates or at the same level, inflation does not pose a significant threat to investors. Therefore, even though your savings are losing value due to inflation, you are earning interest for storing your money in the bank, which offsets the loss.
However, when the inflation rate begins to outstrip the interest rate, which is currently a reality in many countries around the world, there will be a problem to deal with. It is at this point that money that has been sitting in the bank for a long period of time begins to lose its value as each day passes.
Let’s take the US dollar for example. Imagine a situation in which the yearly inflation rate in the United States has exceeded 5%, while interest rates are still at a paltry 0.25%. This means that the value of money saved in US banks is essentially declining at a rate of 4.75% per year. It is therefore more important than ever for investors to hedge against inflation by adding inflation hedging assets to their portfolios.
How Foreign Currencies act as an Inflation Hedge?
As you might know, forex is one of the most liquid and largest financial markets in the world. Foreign currency serves as an excellent tool for inflation hedging as the forex market behaves differently in a recession than other asset classes do.
The stock market, for instance, tends to fall in value during economic crises and recessions. In forex trading, however, the forex market is filled with many different forex pairs, each of which reacts differently to the performance of the economy underneath. During times of economic slowdown or increased inflationary pressures, those currency pairs belonging to a stronger economy will likely gain value, whereas those belonging to a weaker economy will likely lose value as a result.
While investing in foreign currencies is an effective way for investors to hedge against inflation, the key to success is largely determined by what currencies they pick to trade. To be successful at hedging against inflation, you should invest in the currencies of major economies, since they will provide you with better protection from exchange rate changes. Here is a list of the Most Popular Currencies on the Forex Market for your reference.
Several factors make Forex trading a safe hedge against inflation:
- Foreign currencies are backed by reliable political systems.
- The forex market reacts differently in a recession than other asset classes, making it profitable even during recessions.
- The forex market is global, so as long as there is an open market somewhere, trading can occur almost continuously.
- The Forex market is the world’s most liquid market, where assets can be bought and sold with little effect on their value.
- Some forex brokers also encourage traders to engage in forex hedging, which involves opening new positions in order to hedge against adverse price fluctuations.
- With forex trading, it is possible to make a profit by going both long and short, which is not the case for many other assets.
- Forex trading involves predicting the future price of currencies, so anyone can make profits by anticipating the market’s direction.
- While other markets close at night, forex provides 24-hour trading, so you can remain diversified while also continuing to trade.
- With a forex portfolio, you can trade a broad range of currency pairs that include, indices, metals, energies, commodities, and cryptocurrencies.
Understanding inflation can be challenging. However, the good news is that it is also a rare occurrence. It is important for traders to plan to protect themselves against inflation as a core part of their trading strategy. While there are various ways to diversify your portfolio as a hedge against inflation, trading forex is probably the best way to keep you from falling victim to inflation.
What Makes a Currency a Good Inflation Hedge?
The ideal assets considered for inflation hedging are “Safe Haven” assets, which refer to investments that will not lose their value with inflation or appreciate in value during turbulent times.
When it comes to forex currencies, the most viable inflation hedging currencies are from economies with strong net foreign asset (NFA) positions, which is the value of the assets that country owns abroad, minus the value of the domestic assets owned by foreigners. The indebtedness of a country is reflected in its net foreign asset position. When volatility and weak risk markets prevail, some countries sell their foreign assets and bring their money home. Ascertaining that certain currencies have strengthened historically during times of “risk off”, forex traders might also buy those currencies with the expectation they will react similarly.
The three most popular safe haven currencies (and their related safe haven investments) to hedge against inflation include the US dollar (USD) and US Treasuries, the Japanese yen (JPY) and Japan`s government bonds and the Swiss franc (CHF) and Swiss government bonds.
Learn why these three currencies are the strongest, most resilient, and most reliable safe haven currencies for inflation hedging.
1. US Dollar – Global Reserve Currency
Since the US economy is the strongest in the world, the US dollar (USD) is frequently used as a safe haven currency. Comparatively, the USD has maintained a stable interest rate and exchange rate for a long time.
The USD plays an important role in many global business transactions and is not adversely affected by domestic or international uncertainties since it is used as a global reserve currency. Furthermore, the dollar is one of the most liquid currencies on the foreign exchange market, so it is easy for traders to convert their assets into it.
Learn what the strong US dollar has to do with the global economy – and how to use it to your advantage.
2. Swiss Franc
The Swiss franc (CHF) represents the national currency of Switzerland. A low unemployment rate, neutral government, tax-friendly policies, and low-volatility capital markets make the Swiss franc a desirable currency that can be used for inflation hedging. Due to its independence from the European Union (EU), Switzerland is not affected by the negative events that occur in the Eurozone, and it has also become a popular tax haven for wealthy individuals.
During times of stock market volatility, the Swiss franc is often in high demand due to the country’s robust economy, neutral foreign policy, historically low inflation and safe banking system.
3. Japanese Yen
A safe haven currency list would not be complete without the Japanese yen. There are a number of reasons why the yen makes an excellent safe haven currency. A decline in the US stock market often leads to an appreciation of the Japanese yen (JPY). Several investors believe the Japanese yen is a strongly liquid currency, and that Japan’s economy is stable and strong.
The Japanese government, business owners, and individual investors often hold large amounts of overseas assets, earning them the title of “world’s largest creditor”. However, when the economy is tumultuous or panicky, Japanese investors sell their overseas positions and convert them back to yen. Consequently, the yen’s price rises as demand increases.
Find out Which Major Forex Currencies Performed Well In 2022 to help you make informed investment decisions.
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