MY last article focused on the ‘US 10-year bond yield’, which spiked above 3%, triggering panic in equity and currency markets. The sudden realisation that the Federal Reserve was returning to a “normalised monetary policy” and all the blow-through that this has on markets.
A return to more normalised interest rates, provides alternative investment opportunities to equities, thus provoking a major sell-off in US share markets.
The other major impact of rate rises is to ratchet up the costs of debt servicing. This would place enormous pressure on heavily overburdened debt markets including both the private and public sector.
US 10 year bond yields remain above 3% but the sky has not fallen in? Equities have resumed their inexorable and relentless bull market and the higher rates have supported the stronger dollar. The EU has, in contrast, been in an economic slump. The long list of banal and anaemic economic data, confirmed by insipid growth is reflected in the CPI statistics. This has forced the ECB to keep the money-printing machines running hot with quantitative easing (QE) in full force. They now operate in a completely different economic cycle than the US. The euro has reflected this, with the single currency plunging to 1.1800, while the pound sterling has collapsed back to 1.3500.
Central bank activity continues to play a major role in market direction and currency moves. The latest announcements came from the Bank of England and the RBNZ, who both refused to act on interest rates, citing weak economic environments as an excuse to retain extreme levels of QE. This had an immediate and abrupt impact on the associated currencies, with the GBP collapsing to 1.3500, while the New Zealand dollar fell out of bed (0.6850)! The Fed will likely continue to raise interest rates, another three times, through the calendar year. The aggression of the Fed is in stark contrast to the ECB, BofE, RBA and RBNZ.
The Australian Government released its latest budget, which was widely applauded, as revenues continue to improve. The Government has elected to spend this new-found wealth on a popularity inspired mix of tax cuts and debt reduction. The fiscal position, although improved, remains perilous and economic growth assumptions are brave. Growth remains a major challenge to the Australian situation, but is still more positive than the UK, Europe, Japan and New Zealand. These neighbours remain in a completely neighbourhood and economic cycle than the US.
These nations operated in a heavily indebted environment before the GFC. Keynesian economics demanded increasing deficit spending and debt, to combat the GFC and now all these nations are living in a world of extreme indebtedness. Debt is now being recognised as a major threat to economic security and viability. The debt is manageable because of the historically low interest rates foisted upon us by Central Banks and their extremely accommodating monetary policies. This is why markets panic when the Fed raises rates.
Geo-Political and Economic Events
Looming trade wars and the immediate threat to the global economy have been superseded and overwhelmed by a new narrative, Iran and the Middle East. Trump has pivoted and focused his attention on the Middle East, withdrawing from the “Iran Nuclear Deal”, meanwhile recognising the Israeli capital as Jerusalem. This is the latest “chaos” unleashed on the world which could end in a total apocalypse!
From this latest bedlam will come a new Trumpian solution, like a phoenix rising. The latest devastation has been interrupted with some spanners being thrown by the “Rocket Man” in North Korea. Apparently Dear Leader has read The Art of the Deal. The US and North Korea had set a date for peace negotiations to commence in Singapore, the 12th of June, which they have now threatened to walk away from. This is straight out of the Trump playbook. “The more you are prepared to walk away, from the deal, the more leverage you have!” Trump has many balls in the air!
Trade negotiations with China continue and there are signs of progress. The trade negotiations are central to the North Korea deal and intrinsically linked to any successful outcome. These negotiations are a forerunner to other deals (i.e. Iran) and set an example to their leaders. All cards remain on the table and the orthodox complexity of the situation is challenged by the simplicity of Trumps solutions. Trade agreements and sanctions, Military action and peace treaties are a heady mix of the “carrot and stick”.
Markets remain fluid and volatile and the narrative changes as often as the weather. Underlying economic data remains the baseline story, but it is the interpretation of these statistics and sentiment, that drive market direction. As outlined in previous articles, Trump and his administration remain the central character in this epic play, controlling the written script and any alterations made along the way. Governments control fiscal operations, but have largely lost control through incompetence, while Central Banks remain the other major actor that impacts markets.
Footnote: Foreign Exchange and Risk Management
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 cashflows. Once this has been established there are financial instruments available mitigate exposure.
Once a position is established we need to then adopt a risk management policy, which 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.
* Paul Bettany is a foreign exchange partner at Collinson & Co
Is Paul on the money? Or has he missed a trick? Comment below and get the debate rolling.