What to do with currency risks

 

Given the pronounced recent weakness of the Pound Sterling against the US Dollar and Euro, we thought it could be helpful to share our views on the current and potential future drivers of the exchange rates that matter for many of our clients.

 

The toxic combination of extreme inflationary pressures globally and a growth slowdown have wreaked havoc in financial markets, including foreign exchange prices.  

 

On one side, supply chain and energy market disruptions have resulted in double-digit inflation for many goods, with food and energy affected in particular.  For the first time in two decades, the central banks on both sides of the Atlantic have become seriously worried about the risk of inflation expectations being unanchored. Hence we have seen an abrupt change in their appetite to increase their interest rates - with the US Fed expected to hike up to 3% by the end of the year. As the US job market remains one of the tightest it has been, the risk of inflation feeding into wages and thus creating an inflationary spiral is the greatest there, leading to expectations for the steepest interest rises and, in turn, translating into the strength of the US dollar.  In the UK, the governor of the Bank of England talked about sounding “apocalyptic” about food price rises and warned they are planning to raise interest rates further.

 

On the other hand, the headwinds to economic growth from supply chain disruptions, lower consumer confidence and geopolitical concerns will restrict the ability of some central banks to hike without sending the economies into recessions. The US is relatively insulated from the effects of the Ukraine war and commodity and food disruptions and thus is expected to fare better than the UK and Europe. This is what was feeding into the persistent US Dollar strength.  

 

While Europe was initially more affected by the war in Ukraine, its more diversified and larger economy is expected to fare better than the UK, which also faces renewed potential disruptions from the risks related to Northern Ireland protocol (Article 16).

 

With many technical levels broken for both Pound Sterling and Euro against US Dollar, many market observers agree that we could see exchange rates dipping below 1.20 and parity, respectively.  It will primarily depend on the resilience of the economies to the interest rate hikes.  A significant equity market correction or signs of the housing market in the US becoming softer are among a few things that could taper the Fed’s ability to hike faster. Consequently, we would need to see that before we expect the US dollar rally reversal.

 

As we often tell many of our customers - currency forecasting is an ungrateful business.  What is more practical, particularly in the environment that we have entered recently, is having robust processes to manage currency risks before they become a severe problem.  We can always discuss with you where we think the rates are going and if a given level could be the right level to buy or sell, but those are just informed opinions on one of the most unpredictable markets - no one can reliably predict how economics, geopolitics or financial flows will affect exchange rates tomorrow, next week or next month.  Instead, we feel it is important to reiterate some of the ingredients of any robust risk management approach:

 

- Don’t let risks build up - partial early visibility is better than nothing. Businesses often don’t have tools or processes to help them evaluate the magnitude of currency risks they may have. Hurdles such as manual workflows, incomplete data and last-minute changes & delays can get in the way of having good visibility of one’s currency exposures.  However, gaining visibility on a significant portion of currency risks is almost always possible. And managing currency risks even with partial data can have a disproportionally positive impact on your business. It is usually better to handle 70% of risks that you can estimate than manage nothing because you didn’t have the complete picture.

 

- Focus on currency risks, not exchange rate levels.  It is a common mistake for businesses to let currency risks build up while waiting for a particular rate level. During turbulent times, such as now, exchange rates become less predictable and revert less to their “averages”, so basing one’s strategy solely on waiting for a better level can become a slippery slope, as evidenced by the recent currency moves.  Instead, we recommend that our clients focus on their overall exposures and deal with them regularly at frequent intervals.  The objective should not be getting the best exchange rate but smooth and predictable cash flows and profits from your core business.

 

- Take time to understand the impact currencies have on profit margins.   A foreign currency contract, such as a payable for an FCL job for a freight-forwarder from February, left unprotected from currency fluctuations and paid in late April, ended up costing almost 8%.  This is a relatively rare occurrence but highlights the risks that one takes trading internationally.  Protecting from such events costs a small fraction of the potential downside - at HedgeFlows, we are working very hard to make it as affordable for growing businesses to be able to do so.  Understanding the impact that currency swings can inflict on your profit margins versus the costs is the cost/benefit analysis worth doing.

 

Any questions - just hit reply on this email. We are always here to talk to and help our clients, especially in these turbulent times.

 

The HedgeFlows team