Adopting a foreign exchange hedging policy is one thing;
sticking to it in the midst of chaos and confusion such as we have
seen recently is another. I have had many conversations recently
with treasurers and CFOs - most start with one of the following
comments:
- "I hedged all our currency payables for the next year a few
months ago. They are now under water and I am getting a lot of
questions from our board. Should I unwind them all and get out
before things get worse?"
- "We have large balances in our euro account. I thought the euro
would keep appreciating. What do I do now? I am very concerned, but
hedging my exposure now, after the euro has fallen so far, seems
very risky."
- "We don't hedge our currency exposures and much as we would
like to, I don't think we can start now - markets are far too
volatile."
These comments, in my opinion, miss the point of hedging economic
(not accounting) exposures. The purpose is
not to time the markets, trade the
markets, or take a view on currencies. If you asked any corporate
treasurer or CFO if that was their intention, they would vehemently
deny it, but that is what the comments imply.
The reasons to hedge exposures
should
include the following:
- Reduce income statement volatility through managing FX
risk
- Increase the predictability of payments and receipts, thereby
helping the forecasting and planning process
- Maintain a competitive edge in foreign markets, while
minimizing risks
- Remove foreign currency from the list of day-to-day concerns
and focus on the underlying business, which is where core
competence lies
If you followed those guiding principles, you would carefully
analyze your exposures, devise a hedging strategy in consultation
with your advisor and implement it. Once the strategy is in place,
be consistent and stick with it. If you stop and start, you are
timing the market. If you unwind hedges that are under water, you
have a realized loss and are now un-hedged (i.e. exposed) again -
you are essentially betting that you can put on the hedges again at
a better level than where you unwound them. If professional foreign
exchange traders do a poor job predicting currency movement, why
should a corporation expect better results? That being the case,
consistently following a hedging policy is the only sensible,
conservative approach.
Bear in mind that the purpose is not to make money from foreign
exchange transactions. The purpose is to reduce foreign exchange
exposures to a manageable level. Since most companies hedge at a
percentage lower than 100 percent, if hedges are losing money the
underlying exposure is probably making more, so the net P&L is
positive. In a perverse way, therefore, companies should actually
want to lose money on their hedges (not that saying that to your
boss is necessarily the wisest course of action).
It is important to get buy-in and set expectations. A good way to
do that is to build consensus while designing and putting in place
a foreign exchange policy. Once adopted, it should reflect all the
relevant opinions and concerns, hopefully minimizing
second-guessing when things occasionally go awry - and they usually
do.
The road ahead
As I expected, the dollar and JPY weakened slightly last week. A
somewhat healthier tone to the credit and equity markets helped
reduce risk aversion and led to a partial correction of the recent
rally for both currencies.
However, the dollar looks set to gain somewhat further vs. most
major currencies over the coming months, as slower growth and lower
rates are priced into the EUR, GBP and others. U.S. rates will
probably bottom around 0.5 percent (currently at 1 percent), while
EUR rates could drop to 2 percent next year (currently at 3.75
percent) and GBP rates to around 2.5 percent (currently at 4.5
percent). Both the ECB and BOE are expected to cut rates by 50
basis points this coming week and I believe they will ratify market
expectations, with an outside chance that the BOE will cut rates by
a full percentage point. The key questions, in my opinion,
are:
- How much of that interest rate convergence has already been
priced in by the currency markets? I believe the debt and currency
markets have recently priced in virtually all the convergence I
expect.
- Is there more turmoil is in store for the financial markets?
Probably some, but (with some luck) not another major meltdown -
obviously, this is hard to predict.
- How much position liquidation and USD repatriation remains? I
believe we have seen the majority of the move. Most hedge funds
will know by mid-November how much more they need to liquidate to
fund end of 2008 redemptions. They played a large role in the
selling and things should settle down once they are done.
Barring another financial meltdown, my sense is we have seen well
over half the dollar rally we are likely to see for this move. The
precise lows are hard to predict, but in my opinion 1.15 for the
EUR and 1.40 for the GBP are key levels to watch.
The JPY's fate is tied to the level of risk aversion and the
performance of financial markets; it tends to outperform when
equities sell off and risk aversion is high and clearly this has
been the case recently. I expect the JPY to continue to outperform
most major currencies for the next couple of months, but gradually
lose its luster as we head into 2009 and the global economy begins
to stabilize or even recover. I expect the 88-90 area to be a key
level for $/JPY.
I would group other currencies into three categories:
- The stronger EM currencies (CNY, BRL, RUB, SGD, TWD, etc.):
They should do well when the global economy rebounds, as their
fundamentals remain sound, growth has slowed but remains robust and
well above the G10 countries and they are at levels that offer
value once risk aversion and flows return to "normal" levels
- The somewhat weaker EM currencies (KRW, PHP, INR, many Eastern
European currencies): This group will struggle a while longer. Many
of them have run up deficits and drawn down reserves in recent
months and are impacted to a far greater extent by equity related
outflows. Expect more currency turmoil, market intervention and
domestic interest rate volatility until things settle down
- The commodity currencies (AUD, NZD, CAD, etc.): Much like the
first group, fundamentals are fairly good, but the currencies have
been punished as commodity prices have plunged and negatively
impacted their economies. Even though economic growth has slowed,
these currencies are positioned to do better once commodity prices
stabilize and risk aversion declines
It is important to bear in mind that the recent strength of the
USD and JPY is not a vote of confidence in those currencies or
economies - it is a move out of other currencies, accompanied by a
large dose of panic. The dollar has many long-term negatives and
headwinds - it is only a matter of time before they reappear.