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3 Ways Hedge Funds Will Strengthen as Higher-For-Longer Interest Rates Linger

The strong increase in global interest rates throughout 2022 and 2023 has provided a series of unconventional opportunities and risks for hedge funds. Now, as rate cuts still appear to be some months away, resourceful funds have the chance to capitalize further. 

While Wall Street has largely welcomed the news that CPI inflation data cooled to a softer-than-expected 0.3% increase in April 2024, representing a 3.4% year-over-year (YoY) total for the month, the persistence of inflation rates has been confounding for financial markets. 

Hopes for Fed rate cuts as early as Q1 2024 quickly evaporated as confounding CPI data emerged at the beginning of the year. Since then, stubborn inflation data has pushed back expectations of rate cuts to the end of 2024, indicating that hedge funds will be required to embrace high levels of inflation for longer than initially anticipated. 

Fortunately for hedge funds, periods of market uncertainty and volatility can be opportunities to thrive. Building on strategies that serve little correlation to high interest rates, hedge funds have a strong history of navigating challenging economic conditions well. 

However, less dynamic institutions can be more prone to struggling, and rethinking portfolios against the backdrop of confounding inflation data can require a fundamental shift in strategy to tackle unexpected challenges. 

With this in mind, let’s explore three key opportunities for hedge fund managers to strengthen amid a higher-for-longer interest rate environment:

1. Utilizing Merger Arbitrage

For hedge funds seeking to capitalize on periods of high interest rates, there are a number of strategies to explore. However, few have the earnings potential of merger arbitrage. 

Looking at historical data, merger arbitrage is one of the few asset classes that’s yielded a positive correlation alongside rising interest rates. For instance, in the mid-2000s, as short-term interest rose sharply, merger arbitrage index returns improved, while the historically low rates that bookended this period brought declines in index returns. 

This correlation has continued throughout recent years and has consistently yielded a positive correlation with interest rates as historical lows gave rise to a series of increases from 2022 onwards. 

This sector isn’t simply dependent on its relationship with interest rates. Merger arbitrage has coped well in the face of regulatory scrutiny, and with a growing number of M&A deals that have been backlogged due to the uncertain economic climate in recent years, hedge funds can find plenty of joy in the market moving forward.

2. Embracing Fixed Income Relative Value

Higher-for-longer interest rates can increase volatility throughout fixed-income markets, and this generally paves the way for higher returns across these trading-focused strategies. 

Through the hedging of both interest rate and credit spread risk, hedge funds can leverage a strong return through alpha and limit market beta. These strategies bear a lower correlation with wider capital markets, offering a greater level of protection against sustained periods of market sell-offs. 

While there is still much uncertainty about how higher-for-longer interest rates will impact markets and the economy at large in the US, the prospect of a more sustained downturn can still offer opportunities for hedge funds to maximize their profitability by embracing fixed income relative value. 

There can also be potential in fixed income arbitrage, and the promise of healthy returns from risk-free government bonds. For fund managers using arbitrage to buy assets or securities on one market to sell on another, lingering volatility from interest rates can aid deeper price discrepancies and the potential to maximize yields.

3. Looking to Portfolio Rebalancing

The pressures that high interest rates place on economies are uneven across the world. This means hedge funds can navigate uncertainty by taking a more global approach in rebalancing portfolios and embracing systematic macro strategies. 

Systematic macro focuses on directional and relative value trades throughout global asset classes. These offer far greater levels of diversification when domestic markets are subject to volatility. 

Because the post-pandemic recovery has been uneven throughout economies worldwide, the opportunities offered by systematic macro diversification as a portfolio rebalancing technique are exceptionally strong. Particularly in Asian markets that have featured a varied response to the pandemic and central bank monetary policies that shaped respective economic recoveries. 

At times of high interest rates, various signals within this trading strategy can take on different forms. For instance, carry trades can benefit from diversification but value trades could be adversely impacted. However, the larger scale diversification of risk throughout global markets can help to deliver a more sustainable level of outperformance for portfolios in high-rate environments. 

To fully embrace this global outlook, it’s worth looking to a prime broker that features extensive access to global equities, FX, commodities, and indexes through its synthetic prime offering. This can pave the way for a truly dynamic and diversified portfolio rebalancing strategy. 

Navigating Uncertainty

The first half of 2024 has shown that interest rates are fully capable of confounding markets and undermining investment strategies at a moment’s notice. The S&P 500’s flat-footed reaction to the hotter-than-expected CPI rise in inflation saw more widespread uncertainty flood back into Wall Street at a time where just a quarter prior, funds were betting on the arrival of a dovish reversion from the Fed. 

This lingering uncertainty can hold plenty of opportunity for hedge funds, and with the right strategy, it’s possible to use market volatility to build stronger portfolios for when skies eventually clear. In the post-pandemic landscape, uncertainty has reigned supreme across global economies. The most adaptable fund managers have embraced this challenging environment and strengthened their position ahead of their rivals.

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