Bradley Silver, Foreign Exchange Consultant
The current “perfect storm” between major currencies, driven in the most part by U.S dollar strength, could result in dangerous levels of complacency among US-based businesses with regards to their long-term foreign exchange exposure.
Major macro and geopolitical events have driven the dollar to record highs against core currencies such as the sterling and euro, with many stakeholders now forecasting this dollar strength will become the norm.
However, this historic backdrop is unlikely to remain in place over such a timeframe and a significant market rerate could see American firms hit with a material downside.
If the situation in Ukraine resolves, for instance, or inflation comes quicker under control, firms that didn’t have the right foreign exchange hedging strategies in place or on the right budgeted rate could in theory be 15-20% out of the money very quickly – wiping out all their profit margins for the next couple of years.
The global currency of oil
The war in Ukraine has profoundly impacted investor sentiment, disrupted supply chains, and helped fuel U.S dollar strength given it’s the global currency of oil. While the conflict has dragged on and blown into a major global risk, its swift resolution has become the number one political focus globally.
Separately, political machinations in Europe – such as the UK with its recent disastrous ‘mini’ Government Budget and in Italy, with the victory of a far-right candidate – have played a role in weakening domestic currencies and further exacerbated differences with the dollar. The result has been, in the case of sterling, the biggest spread since 1984; in the case of the euro, a psychologically significant move below parity with the greenback.
From a U.S. perspective, the U.S. dollar is soaring against most of its counterparts, with the Dollar Index reaching near record highs thanks to the widening interest rate differential between the U.S. Federal Reserve and its peers. Fed Chairman Jerome Powell has doubled down on his aggressive approach to boost rates until inflation is under control, despite recession risks.
The perceived safety of the greenback
The dollar’s role as a global safe haven has also given the buck an added lift. All year global investors have been selling stocks and riskier assets and parking them in the perceived safety of the greenback. This activity has created a perfect storm for an unprecedented dollar rally and record volatility.
However, the U.S. itself could enter a recession over the next six to 12 months, as many banks and financial institutions have warned, and this could see a lot of the dollar’s strength fall away.
For U.S. firms with complex, multiple currency exposures or those looking at exploiting currency weakness to increase cross-border M&A, the current landscape represents significant short- and long-term risks but also opportunities to use the right strategies and market approaches to mitigate those risks.
U.S. corporates that traditionally trade using spot rates may find themselves with challenging scenarios; in contrast, firms that consider using established foreign exchange hedging strategies, such as forward contracts, for instance, can significantly enhance and optimize their foreign exchange risks.
Take a blended currency approach
In a fast-moving market, we believe businesses should take a blended currency approach. One strategy would be to consider using a forward contract to secure a percentage of a firm’s requirement, traditionally between 50-60% of its annual foreign currency need.
Then top this up by working closely with a specialist via market orders and spot contracts to obtain a better overall average price. If they are a true partner, the FX specialist should let a firm know when it’s best to buy while the firm itself focuses on other aspects of their business.
One recommendation right now would be to engage with a provider that offers forward contracts that allow a firm to buy more than a year ahead; some companies offer up to five years ahead.
It’s critical to remember that forward contracts have lots of moving parts. An experienced FX provider will explain everything in detail, including addressing any required margin requirements. These payments are not a premium but rather sit against the value of the overall contract.
Also, depending on the size of a business, options products can show you performance against the current rates and may be worth exploring. Again, it is imperative that U.S. firms looking to enhance and optimize their FX approach speak with a fully regulated business regarding complex derivative options.
Strong demand among U.S. firms for more sophisticated solutions
The role of hedging is expected to grow – Monex USA has seen a 30% increase in hedging in Q3 2022 versus Q3 2021. We have been able to react to a highly volatile market environment and have seen strong and encouraging demand among U.S. firms for more sophisticated solutions.
The hope is that this approach and the underlying strategies become more mainstream at a key time in the economic – and political – cycle.
