BY DEFINITION the Freight/Customs industry is exposed to Foreign Exchange (FX) risk, as it deals with foreign currency receipts and payments. There are financial instruments available to mitigate these risks and the goal should be minimisation, allowing business to concentrate on core business.
To minimise exposure a business may have to FX risk, it is necessary to accurately ‘know your position’ to minimise risk. This is done through accurate forecasting of foreign currency cash-flows. Once this has been established there are financial instruments available to mitigate exposure.
Once a position is established we need to then adopt a risk management policy that takes into account the economic cycle and the risk profile the company is comfortable with. Policy could be anything from doing absolutely nothing, which is a strategy, through to 100% cover for all foreign currency exposure. Ideally somewhere in between these extremes is where you set your policy.
It is this risk management process that must consider the economic environment and the impact on currencies. The ability to absorb currency fluctuations, including profit margins, will determine how much protection is needed. The use of ‘forward contracts’, options and swaps are all instruments used to offset risk.
The story since the last article has gone from ‘Global Trade Wars’ to interest rates and the US dollar. The narrative driving bond, equity and currency markets had been all about the threat to global trade by looming trade wars between the USA and its trading partners. The fear over a global trade war drove equity markets into a global downward spiral and shook up currency and bond markets. The love affair with that looming disaster was soon forgotten, as had the previous geo-political crises surrounding North Korea and markets have moved on to the bond yield crises.
US 10 Year bond yields broke above 3% and this triggered a major sell-off in equity markets and massive disruption to currency markets. The Fed has been in an aggressive monetary mood, fighting surging inflationary pressures, created by strong economic growth. The Fed has moved on from the stagnation of the post-GFC environment into the new growth cycle, dominated by strong growth in capital and labour markets. This is in clear contrast to the other major economic zones and their respective Central Banks. The ECB, Bank of Japan, RBA and RBNZ are still locked in to the low growth economic cycle, demanding extremely generous monetary stimulus, through QE. The exception has been the Bank of England which has actively recognised inflationary pressures (despite Brexit jitters), embarking on a hawkish monetary stance.
The focus on the rise in bond yields has shaken markets. Equity markets have been in turmoil, as the rising interest rate environment, has threatened input costs and provided an alternative investment opportunity for investors. The cost of capital and debt funding are major challenges. The rise in support for the Dollar is a direct result of the pressure of interest rates and the investment attraction high rates provide. Interest rate differentials offer a clear advantage to buy the mighty Dollar. This has seen the EUR fall below 1.2100, while the Yen has broken above 109.25, reflecting the surging reserve. Commodity currencies have experienced an even more severe correction after recent rallies. Commodity currencies rebounded, as fears of global trade threats subsided, allowing trade dependent exporters to flourish. This combined with rising global commodity demand and prices lead to a surge in associated currencies. The advent of the rising Dollar has hit the currencies hard. The AUD rallied to 0.7800, before being hit hard, falling to 0.7550 in the space of a week. Closer inspection of charts suggest major support levels are at still lower levels.
The Federal Reserve has taken the opportunity to raise rates for the sixth time, in this current cycle, with projections for up to three more in 2018. The Fed forecast increased the likelihood of further interest rate rises for 2019/2020. This signals a return to a more normalised monetary policy and a direct result of rising growth prospects and inflationary pressures. This interest rate policy should support the long term prospects of the US Dollar.
Geo-Political and Economic Events
Equity markets remain nervous and are therefore susceptible to extreme volatility. This year has been tumultuous and eventful as the Trump administration seems to thrive on the ‘controlled chaos’. The solutions that materialise from the disorder are surprising and unforeseen. It appears that is the ‘Art of the Deal‘? This completely novel approach to great and pressing problems of our time has turned political convention on its head. Trump throws bombs (both actual and metaphorical) and from the resulting disarray formulates solutions that are unexpected by participating parties.
‘All cards are on the table’ seems to be his mantra.
He approached the North Korea crises in this fashion and appears to be having some success. He has threatened total destruction on the rogue nation, while imposing the most punitive sanctions. He also used bilateral trade as a cudgel to pressure China (North Korea’s benefactor) to force compliance on the Dictator KJU.
This same approach to problem solving has been used domestically to address tax cuts. He has a multi-faceted approach to problems, with employment of a ‘carrot and stick’ philosophy. The creation of mayhem seems to advance the cause of incentive to settlement. Markets will look toward the summit between Trump and Kim Jong Un. Any settlement would be one of the great achievements in diplomacy in a generation.
Trump is seemingly working with his European allies to try and formulate a peace plan in the Middle East and trade is a major negotiating tool. The use of trade as a bargaining chip has been successful in Asia so would it be mad to suggest, it would fail in the Middle East and Europe? Unconventional approaches to world problems have busted the status quo and may lead to unprecedented and unforeseen solutions. Global peace is great for international trade and the international economy.
The World Interest Rates Table
The World Interest Rates Table reflects the current interest rates of the main countries around the world, set by their respective central banks. Rates typically reflect the health of individual economies as in a perfect scenario, central banks tend to rise rates when the economy is growing and therefore instigate inflation.
Rate cuts on the other hand are a way to stimulate a struggling economy. The table above includes actual rates, latest policy changes and the date of upcoming meetings/decisions, for the major ones.
World markets are never dull, boring or static. It is amazing how the drivers of these markets change, so completely, comprehensively and quickly. This year we have gone from a global nuclear threat to international trade wars, to finally arrive at the global growth story with bond yields causing mayhem in equity and currency markets. The challenge is not to predict what will be the next ‘Black Swan’, but how we can manage any and all challenges. We have simple and effective means to avoid risk in our currency markets and prevent the mayhem spreading in to our own personal business environment.
* Paul Bettany is a foreign exchange partner at Collinson & Co