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A few notes on FX (and Twitter…)

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Twitter, it has been argued, has taken all the fun out of comedy. Words cannot adequately express my lack of esteem for its more, shall we say, prominent users who, lacking any filter, continually tweet forth miserable comments on all the ‘whatevs’ of their private or public life. However, Trump’s most recent “Rocket Man” moniker for the North Korean leader is tragically funny, being visually evocative at the same time as engendering an Elton John earworm.

I confess I did not expect that I would be writing about the threat of nuclear war in a commentary on financial markets and risk management. At the risk of appearing cynical, a nuclear war would be great for hedge funds, gold and bit-currencies, since anything that is unencumbered by custom borders or tax will still be here after the dust settles.

Now that I’ve lost your attention, back to business. Summer economic data releases showed the European economy continuing to improve, as global growth was revised higher and world equity indices traded at all-time highs - despite the real possibility that interest rates will move higher at both the front, and back-end, of the curve in the coming 12 months. All is well. The End.

Last week the Bank of England drilled through the core of complacent market players and implanted the idea that in November it will hike by 25bps, causing a stir. Mark Carney did not clarify whether the first hike would simply reverse the post-referendum cut, or if it would mark the beginning of a cycle. At the same time, there was not much discussion on how the Bank will deal with its asset purchase programme, so the outlook on UK rates remains quite uncertain past November. Will there be a hiking cycle? Will the curve steepen, or flatten? The policy news sparked a two-day rally for the pound, which appreciated about 3% against USD and EUR. Some banks argue that the trajectory will continue, on the expectation of a proper hiking cycle; other players dismiss the move as a short-term position adjustment, as they focus more on the persistent issues of Brexit and an uncertain investment environment. The coming two months will tell, and they will be important for EU rates as well.

On 26 October the ECB Governing Council will sit for the next EU monetary policy meeting. The minutes and statement should provide some clarity on the speed of tapering of the ECB’s QE programme, as well as insight into when they envisage raising official rates. Will the statement enlighten us as to how they might go about scaling back the stimulus? Maybe it is too early for that. During the summer months, price and wage inflation continued to frustrate the central bank’s efforts, and this set-up will keep a brake on policy measures until solid improvements start to seep through the data. I find it very difficult to expect that the guidelines for next year’s actions will be especially conclusive. I would, however, predict that the ECB will continue playing with wide time ranges for hiking rates, meaning Euribor will remain in negative territory for a while. EUR/USD is due some volatility: it reached 1.2000 over the summer and weighed anchor here, but while the EUR side of the cross is steady, the same cannot be said for the USD side. US dynamics are very uncertain for all policies – whether geopolitical, fiscal or monetary; and it would be miraculous if none of the above managed to upset the currency markets before year-end.

We are all approaching budgeting season – actually, we have almost finished here at JCRA – and while trying to be operational and practical I’ll fill this space with a few important notes on how (not) to set FX rates for budgeting purposes:

Don’t use FX forecasts, particularly single bank ones, to set one rate for the coming year.

FX forecasts change fast: much faster than your budget. They change because they are mostly based on the spot rate and some known events that the economists discount in their ‘models’. The truth is that FX forecasts in aggregate are only good for getting a sense of market expectations of a trend, i.e. the market expects on average an appreciation or depreciation of the currency cross.

Budget by currency of operation for each subsidiary, then aggregate - not vice versa.

So many businesses fail to appreciate FX risk because they don’t identify the source of the risk from subsidiaries. Large swings in specific currencies, like the GBP depreciation post-referendum, highlight the potential impact of this issue. A UK subsidiary should provide its forecasts in pounds instead of euros; a Swiss sub in francs, and so forth.

Indirect risk is material and should be discussed strategically upon budgeting.

Particularly by focusing on suppliers, the business should have an understanding on how quickly negotiated prices will change on the back of currency fluctuations, and how this could impact profit margins. It is surprising how often managers underestimate the time misalignment between fluctuations in input costs and sales prices driven by currency movement. If the difference is substantial, there may be an FX problem. If the difference is growing and sticky, the FX problem could become huge. The many UK retail businesses having difficulties and going into administration are a case in point.

FX volatility is real – budgeted FX rates should take it into account

Business plans, investments and sales pricing models should still make sense and be profitable after factoring in the prevailing FX spot rate, the prevailing FX forward rate for the period and after adjusting for one standard deviation of adverse FX movement. This will ensure your business plan will be fine in about two-thirds of possible FX outcomes. Depending on the business view, that may not be enough. Should margins be low, FX hedging is essential for profitability and is not just an opportunistic choice.

All views expressed here are the author’s own and are based on information available at the time of writing.

 

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