Implications from a changed World for Risk Mitigation

This has 3 significant implications for risk mitigation:

1. Markets are (even) less predictable: Forecasting exchange rates and interest shifts has always been difficult. It will become even more challenging, however, if the reaction functions of policymakers’ change. A case in point is the unprecedent level of effective tariffs the US has imposed on itself, at least for the time being (i.e. it is unusual for policymakers to actively initiate a large short-term hit to their markets). 
   A broader point to consider is that the impact of some forms of geopolitical risk are quantitively difficult to determine. For example, although it seems increasingly likely that the US’ relations with some of its global partners could deteriorate, it is difficult to rigorously fully quantify the mid and long-term implications for markets.  India’s Institute for Risk Management coined the phrase “black jellyfish” risk for such “unknown, knowns.” 
2. Macro, policy and market volatility is likely to remain elevated: In addition to less predictable economic outcomes (chart 1) and policymaker reaction functions, there is an increased risk of rapid changes in policy. This has recently clearly been witnessed with respect to ongoing frequent changes in US tariff policy, with associated implications both for macroeconomic forecasts and risk appetite (i.e. both of which impact FX and interest rate levels).

3. There is an increased risk of extreme outcomes: Perhaps the most important change for risk management is the increased risk of extreme market outcomes. This doesn’t mean that extreme outcomes are the most likely scenario but could mean that tail risks are increasing. A key issue in market focus is whether the US Federal Reserve will face increased pressure to adopt a looser policy than what the inflation outlook realistically permits. This, alongside concern that a US trade war will broaden to one involving capital flows, points to increasing tail risks of extreme USD and longer maturity US Treasury bond yield moves.

Less predictable, more volatile markets, with increased scope for extreme outcomes, unsurprisingly have significant implications for risk management: 

1. Hedge ratios: Increased market volatility, with a higher risk of tail events, supports risk reduction.
   
2. Scenario analysis: When risks are less quantifiable using scenario analysis becomes increasingly useful. For example, to consider how different combinations of US Federal Reserve credibility and protectionism could directionally impact key global market metrics (EUR/USD, global yields, equity markets…) and to consider risk mitigation accordingly. This is particularly relevant when considering balance sheet risks.
3. Risk premia: Hedge costs obviously fluctuate over time. Actively tracking the cost of hedging (also versus fundamental determinants) can inform decision makers about when to more aggressively hedge risks. A case in point is that a loss of US policy credibility could both make EUR/USD hedge break-evens more attractive and increase the logic in hedging. Changes in relative USD v EUR yield curve shape could also impact hedging decisions such as lengthening the optimal tenor of hedges.
4. Interest rate risk hedging: The relationship between USD and EUR yield curves has already started to evolve during 2025, against the backdrop of diverging monetary and fiscal policy credibility. This is manifested most clearly in the breakdown in UST-Germany 10y government bond swap spread correlations (chart 2). Additionally, historically high correlations between long-term USD and EUR forward interest rates have also moved lower. The implication for hedging is that increased emphasis should be placed on managing longer-dated interest rate risk (particularly USD) and the “basis” between different curves should be considered, given scope for historical relationships between yield curves to break down (both within the same currency e.g. US Treasury v SOFR swaps and between currencies).

5. Fundamental differentiation in the Emerging Markets and CEE Foreign Exchange: In an evolving global order, it is also likely that markets will increasingly differentiate between countries based on: (i) the impact of US policy changes (e.g. on their exports or US political relations). (ii) the economic and policy sheet flexibility countries have to respond to any economic shock from US policy -> This has particular relevance for Emerging Markets and CEE exchange rates, where countries with larger economic exposure to the US but less domestic policy space are more vulnerable. 

The bottom line: Significant changes in the US economic and security policy orientation both has significant short and long-term implications for global markets and for risk mitigation. To conclude with a 17th April quote from ECB president Lagarde; “We are not in a shock free world, that’s for sure.”

Martin Blum

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