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Foreign exchange rates are deceptively simple. On one level, they’re just the price of changing one currency into another; on a more detailed level they’re a reflection of a huge variety of global events and political manoeuvres. In the long term, foreign exchange rates are dictated by the perceived relative growth opportunities an economy offers. These are judged by either its economic data or by indirect indicators (which may have a very direct financial impact), such as interest rates.
It is helpful to see foreign exchange this way when your firm is planning international business for the long term. It can be used to predict pricing and revenue, or costs paid in a foreign currency. However, when the business is executed, as opposed to the budgeting and planning phases, the world can become a lot more uncertain. Central bank announcements and world events can make the markets change very quickly. This can have a large impact on:
- overseas earnings
- the ability to repatriate funds
- translating overseas earnings back into a company’s domestic currency.
This becomes particularly relevant in times of economic and fiscal uncertainty (like those we’ve seen over the last few years). Two current events can help to illustrate this point.
The European Central Bank and increased quantitative easing
The principal economies in the Eurozone have been in low growth mode for some time, and this has depressed the price of the euro. Rates have also been low because of various quantitative easing (QE) measures used by the European Central Bank (ECB), which has attempted to stimulate demand and investment in the Eurozone by making funds available at a cheaper price in an attempt to increase growth, despite sluggish inflation.
One of the first signs that the Eurozone’s economies are beginning to pick up would be a rise in the rate of Eurozone inflation – hence the large amount of interest generated when economic data is published, and the subsequent policy statements by the ECB.
In October this year there was a feeling that there may have been positive sentiment on economic growth, and this would have raised the value of the euro, both because of underlying economic optimism and the feeling that interest rates could start a long, slow recovery to more “normal” levels (i.e. pre-2008 levels). As it happened, inflation did not pick up, and nor did the ECB add further stimulus. Interest rates were held at record lows.
As December started we found ourselves, once again, waiting for an ECB policy announcement. This time, the expectation was that low growth and low activity in the Eurozone would push the ECB to announce further QE measures, with the side effect of pushing the euro to lower levels. As events proved, expectations are not realities.
On 3 December, ECB President Mario Draghi actually announced that there will be no extra monetary stimulus each month, although QE will be extended until “at least March 2017.” The deposit rates have also been cut by 0.10%. Though the ECB has extended QE, markets were dealt a huge blow as the expectation was for an extra €10 to €15 billion a month. The hopes were not unreasonable, as Mr Draghi had indicated that he wants a weaker euro and for inflation to pick up in the Eurozone. The ECB’s soft approach was therefore a surprise and a disappointment, and the euro strengthened considerably.
This means that the value of the euro could be at an inflection point, which could be very bad for companies exporting into the Eurozone.
The point is that, no matter what signals the central banks send in the run-up to an announcement, until the announcement is actually made there is no way of knowing with absolute certainty what is going to happen and how the currency markets will respond. It is this ‘event risk’, and the sudden price movements that go with it, which businesses need to protect themselves against.
US industrial and manufacturing production data
Monetary policy between the US and the Eurozone is increasingly divergent, which makes keeping up with developments even more difficult.
On 16 December, November data for industrial and manufacturing production will be released. There is an expectation that this will beat estimates, and this could then be interpreted by the Federal Reserve Bank as a trigger to increase US interest rates reinforcing Fed Chair Janet Yellen’s statement that the US economy is doing well and perfectly poised for an interest rate rise.
This would make the US dollar an even more attractive investment currency, and more valuable as demand for it increases. The rise in the dollar’s value would be good news for companies importing from the US but less good news for companies selling materials or services to the US.
Whether importing or exporting, there will be a sharp financial impact on non-hedged cash flows for companies trading with the US.
At Currencies Direct, we believe in keeping our corporate clients abreast of these events.
Although it is possible to react after they have happened, this is likely to result in an unpredictable financial performance. In our experience, companies often find it beneficial to be pro-active and to design a hedging approach to these risks, through a combination (where appropriate) of forward contracts and options*.
* FX options can carry a high level of risk and may not be appropriate and/or suitable for everyone. Please take all reasonable steps to understand certain key concepts before transacting in FX options. More information is available at currenciesdirect.com/options and in our product disclosure statement.