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FX – Some summer reading

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Currency markets tend to stabilise during August because most market players take a well-deserved break and, to ensure they can do so away from the glare of their Bloomberg screens, neutralise their open positions as far as possible. The others avoid trading in lower liquidity and less volatile markets if they can. Most of these market players are portfolio managers investing in financial markets, or traders who spend most of their time searching for and betting on opportunities for the market to move (volatility), whether in a direction they have foreseen or following a trend (volatility + momentum). As such, it is not a bad time to set the scene and try to look forward on the currency markets.
 
Both Trump’s administration and the greenback are failing to accomplish the great achievements that they were promising nine months ago. At the time, a number of investment banks and economists were forecasting EUR-USD at or below parity and GBP-USD close behind (this implied EUR-GBP close to parity too, but more on that later). Similarly, the new President of United States was due to Make America Great Again, possibly boosting the USD thanks to (amongst other things) substantial investment in infrastructure and the repatriation of US companies’ income held in foreign subsidiaries.
 
With the exception of EUR strengthening on GBP towards parity, none of this has yet materialised, and in fact today’s picture is quite different:
 
•  EUR-USD and GBP-USD trade at 1.1640 and 1.3045, showing an appreciation of 6.5% and 6.4% respectively over the last nine months;
 

•  Europe’s economy has been improving on almost all fronts, and in almost all countries for the past 12 months, with the notable outcomes of EU unemployment dropping below 10% and  Greece returning to the bond market;

•  Trump’s policies have been revealed to have very short legs, with a logjam in Congress over the repeal of  ObamaCare; and

•  The USD Index has lost 4.3% since the US Presidential elections

It is true that the Fed and the global economy (read: China) are not very happy about USD weakness, but the US Treasury has a not-so-secret preference for a weak dollar. Trump himself is proving incapable of delivering on those policies that could invigorate the country and support the currency in tandem. So, unless the US populace gives up on its President and carries on as if nothing were wrong, if the Federal Reserve does not find a way to continue the plan to normalise its monetary policy, we are likely to see more USD weakness over the coming months.
 
For those who looking to hedge themselves against a stronger EUR, we note two things:
 
  1. FX option markets are more favourable than they have been in a long while. Looking at the past 10 years, implied volatilities (Chart I below) are close to the lowest levels since 2014 and only 2007 before then;
     
  2. The one-year FX Carry (Chart II below) is at its highest levels since 2007, and indicates that hedging via FX forwards would cost an extra 2.11% (not inclusive of transaction costs) on the hedged notional. Hedging 'right hand side' EUR-USD with FX forward has never been so costly.

EUR_USD_Implied_Volatility

EUR_USD_FX_Carry

On EUR-GBP, one can see a remarkably similar pattern: weak policy-making, a difficult regulatory framework, and uncertain economic patterns. Sterling has become weaker and weaker thanks to, amongst other economic factors, the UK’s political situation, including an indecisive General Election that has resulted in weak government and limited impact at the first round of exit negotiations with the EU. This is clearly affecting businesses across the Channel, and has given rise to some tricky questions over the past few months:
 

•  Is the GBP’s weak setup going to change? Not much: politically biased negotiations are scheduled for the next eighteen months at least, and it could take even longer – some commentators say more than 5 years – to find a stable setup between the EU and UK;

•  Can EUR-GBP spot go to parity? It is quite possible that this will happen at some point. After all, it traded around 0.98 sterling per euro at the peak of the UK banking crisis in 2008. Moreover, between cutting old ties and sewing new ones with the EU, and opening new trade routes, it will take a long time for the UK to determine its place in the global economy. 

•  What can you do about this? Once again, not much: the sterling is going to stay weak for at least as long as it takes for the UK’s position with the EU become clear. However, action should be taken on the quality of market risk management:

o    FX risk policies in businesses that have significant exposure to foreign cost and revenues should be imperative. We have spent hours explaining the management benefits of layered hedging programs, for those companies whose business cycles cater for them, and we are seeing more companies in the growth and small-mid ranges digging out their exposures so that they can discuss them at budgeting time; 

o    Unsurprisingly, there are still companies and executives unaware of the currency risk in their businesses because they negotiate in their local currency instead of the trading currency for the product of interest (typically EUR or GBP contracts for commodities whose floating price is quoted in USD). This doesn’t sound right, and in fact it is a simplistic and harmful approach which has led to horrendous consequences for several businesses at difficult times. 

You will forgive me for not commenting much on the rates front. The only key element to highlight is that markets are unwilling to believe rates could move lower, but are terrified by the possibility of the European and American QE programmes ending. If you are going through a financing process in Europe, and you are likely to hedge with an interest rate swap (IRS), keep comfortable assumptions on rates: IRS swap curves have jumped up by 8-10bp higher every single time ECB speakers mentioned the end of the QE program.
 
Enjoy your summer vacations

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