Podcast series: a view from the FX dealing desk
13 April 2022
Listen to commentary from our FX experts on the currency markets.
13 min podcast
The coinciding of Brexit and the coronavirus pandemic has brought once-in-a-generation economic turmoil and a uniquely challenging environment for British companies.
The forces unleashed by the slowdown have delivered a seismic hit to global supply chains and dramatically reduced many businesses’ ability to forecast accurately. And this comes at a time where companies are already navigating a host of potential global flashpoints.
Against this backdrop, a key question is how can a business manage currency risk and manage cash flows when it can’t be sure of future demand?
Adapting your approach to risk management in light of events is nothing new. Before the pandemic, some UK companies had already adjusted their currency hedging strategies after the Brexit referendum. But now, this process of revaluation has been accelerated by Covid-19 and the disruption to supply chains.
Forecasting has been complicated by the potential for a second wave, how specific industries will emerge from the crisis, and the impact on consumption and consumer sentiment. As a result, many companies have entered unknown waters. Some businesses will see acute changes in sales, while others will see varying levels of disruption to supply chains.
The crisis has prompted businesses to consider alternative ways of minimising foreign exchange risk.
As we move through the crisis, we see more and more businesses who don’t have the same confidence in their revenue or cash flow forecasts due to the historic challenges they face. Consequently, in such circumstances, the traditional practice of using forward contracts to hedge foreign currency risk may not be appropriate. While forwards have typically allowed businesses to lock in rates to create better visibility around forecasting and protecting margins, there is little flexibility.
The crisis has prompted businesses to consider alternative ways of minimising foreign exchange risk and we will increasingly see treasury functions, chief financial officers and financial directors seek more flexible ways to manage risk. The good news is that there are solutions that can be tailored to help business mitigate risk and build greater layers of predictability and visibility.
Inferring your currency requirements from what you did last year may no longer make sense. This year already looks completely different to 2019, and 2021 will look different again. Furthermore, the dislocation we see in global currency and asset prices is also adding fresh complexity. That has created new headaches for treasurers seeking to reduce risk.
For example, for years, the approach to the dollar has been a relatively simple science from a currency perspective - if risk sentiment across the globe is deteriorating, the dollar will strengthen and vice versa. But we are now seeing increasing signs we can no longer rely on this dynamic.
If you look at this year's emergence of gold, you can see how investors are adapting to global risk, and the yellow metal has been the haven front runner over the dollar. The greenback from a position of strength has been thrust into bear market territory. How investors and institutions view the new global risk perspective will have a knock-on effect on currency markets for years to come.
The approach to the dollar has been a relatively simple science from a currency perspective - if risk sentiment across the globe is deteriorating, the dollar will strengthen and vice versa. But we are now seeing increasing signs we can no longer rely on this dynamic.
Given this volatile landscape, corporates need to be careful about extrapolating this year’s currency requirement with on-going fixed hedging obligations for the future. Blindly moving forward with fixed forward obligations for 12 months ahead is unlikely to be an effective risk-mitigating strategy or appropriate given the potential for uncertain cash flows and rapidly changing demand.
Clients can instead access solutions where they can still ensure guaranteed cover on risk, but have flexibility on the amount of foreign currency they purchase – effectively an options strategy.
Previously esoteric, adopting options strategies to currency risk is now much more broadly understood and used by an increasing number of corporates. Forwards allow businesses to lock in a future exchange rate with lower costs upfront, but the contracts are binding. In contrast, options give the company the right, but not the obligation, to buy or sell a currency at a specified exchange rate on or by a given date.
Clients can access a full spectrum of options – from plain vanilla options, where there is a zero premium and still an underlying protected rate, but a degree of flexibility around the amount they take delivery of, to a participating forward - which allows the client to protect 100% of their given requirement but engineering flexibility on a given percentage by fixing the protected rate slightly lower than a forward.
The market is also waking up to new risks. Brexit is creeping back up the agenda. However, given the broader global currency dynamic, sterling has been at the mercy of fluctuating euro and dollar movements.
For example, despite the upcoming cliff-edge Brexit deal negotiations, sterling has been quietly appreciating against the deteriorating dollar.
‘Managing sterling and global currency risk volatility may never have been harder.’
UK businesses looking out from their doorstep have realised that there is currently a lot beyond their current control – and managing sterling and global currency risk volatility may never have been harder.
Central to the difficulty is that currency shifts are no longer dependent on fundamentals. For example, the dollar’s behaviour at the beginning of the crisis was fuelled by a funding dynamic where institutions were trying to grapple with a dearth of dollars, regardless of fundamentals.
Adding to the uncertain picture is the evolving shift away from trade reliance on China. This pivot away from the Asian powerhouse to other low-cost manufacturing centres brings diversification benefits, but also potentially creates a new level of heightened currency risk.
While China was the first victim of the global pandemic, the yuan has exhibited one of the lowest levels of volatility among emerging-market currencies during the crisis, with the country’s central bank setting a reference rate every day. Its historical level of predictability has helped UK companies doing business there with visibility and forecasting.
But as the shockwaves of the coronavirus pandemic settle, our clients are making real attempts to diversify their supply chain relationships away from China. There is an obvious logistical challenge to this process, but it also means re-sizing risk around the new currencies that they must consider, which may bring more erratic and unpredictable price swings.
For example, while Turkey is a jurisdiction that clients are increasingly accessing for trade, there is a currency risk element. That means there must also be an effective foreign exchange strategy to manage the relative risk of a more volatile lira versus a relatively stable Chinese currency.
Adding a final seam of uncertainty is the upcoming US election. Key questions remain over healthcare and taxation, but it does appear that President-elect Biden will be more consensual and prudent. This election is certainly more complex than usual, but the fact it is not centre stage underlines the extraordinary times we live in.
In almost two decades of managing foreign exchange exposure for UK companies, this perhaps the most challenging period I have experienced.
The nature of currency markets means you are always grappling with fundamental risk – government risk, geopolitical risk, policy risk – but one comes typically to the fore. Now all of these risks have been amplified, potentially creating an even more challenging environment than the global financial crisis.
Against this backdrop, understanding business risk and unlocking additional flexibility is crucial. This added layer of planning and optionality will build business resilience, and ensure a more stable, predictable and – ultimately – successful future.