Currency Risk Management Strategies in 2017
13th February, 2017
Author: Adam Smith
The two key events that dominated the international political landscape in 2016 – the June Brexit vote in the U.K. and the U.S. election in November – had a pronounced impact on global foreign exchange markets.
Brexit in particular served as a stark reminder of how quickly political instability can translate into financial market volatility – the almost instantaneous collapse in the value of the pound caught many unaware and the ongoing ambiguity around the U.K.’s exit from the E.U. has ensured it remains a volatile currency that is subject to occasional intra-day price gyrations, particularly against the USD.
As the Brexit dust settled the world turned its attention to the U.S. and the November election. For the weeks and months leading into the contest it seemed a foregone conclusion – it would be Mrs. Clinton off to the White House. Financial markets were relatively calm. However as the polls tightened and a Trump victory became a potential reality a sense of nervousness emerged. What would a Trump presidency mean? No-one really knew.
As the votes were counted and a Trump victory was confirmed we saw asset price movements that challenged the prevailing orthodoxy which dictates that at times of heightened uncertainty it is best to liquidate risky assets such as equities and invest in “safe haven” assets such as gold, Japanese yen and U.S. treasuries. The post-election rally in the USD, S&P 500 and the sell-off in gold, JPY and US Treasuries is not really what the market was expecting (and may have inadvertently ended the careers of some professional fund managers!).
The point of all of this is that in 2016 neither the polls, nor the markets, nor the media were correct in predicting any of these “key event” outcomes. The unexpected results have delivered some large price moves in currency markets. If you had a personal or business foreign currency requirement in 2016 and the price moves worked in your favor – well done. If, as would be the case for many consumers and commercial enterprises, they didn’t go your way you will be acutely aware of how adverse price moves can present a very real risk to your cash flow management.
How will global events affect currency exchange rates in 2017?
As we look ahead to the remainder of 2017, it makes sense to review the calendar to identify other key events that have the potential to cause significant volatility in currency markets. As it happens, we need to look no further than to Europe where elections in three of the founding member states of the E.U. could dramatically alter the European political landscape in 2017.
European elections could make 2017 rocky for international businessesWill the rise of anti-immigration, anti-trade, and nationalist parties continue to grow in Europe? If they gain material ground it may lead to more nations threatening to leave the E.U. as well as potentially making the E.U. negotiations with the U.K. more complicated (if that is possible!). Expect volatility in the euro and sterling, particularly against the U.S. dollar, should political unrest in Europe continue.
Here is a quick recap on what to look forward to in this year’s election calendar:
- The Netherlands Parliamentary Elections - March 15
The Dutch general election is fast approaching and is scheduled to take place March 15th – (Beware the Ides of March?). The latest polls put the PVV or Freedom Party, led by Geert Wilders, in the lead. The risks of the PVV winning are clear as this is an anti-E.U. party that has a desire to see the Netherlands withdraw from the E.U. if it gains power. There are widespread concerns the Netherland’s elections could be the first step in a sequence to a 'Nexit' and the break-up of the E.U. Such an outcome could be negative for the euro so this election poses a major risk to the value of the currency.
- The French Presidential Election - April 23
The anti-E.U., anti-immigration National Front Party, headed by Marine Le Pen, has everyone’s attention. The National Front is currently polling around 24% - 26%, which puts it in first or second place, depending on the opinion poll. A victory for the Le Pen would not augur well for the E.U. – however opinion polls, as we now know, have not necessarily been good predictors of election results in the recent past.
- The German Bundestag Election - September 24
Angela Merkel is the incumbent German chancellor and is running for a fourth term. The polls are suggesting that Ms Merkel’s center-right Christian Democratic Party will win, though it will likely lose seats in the Bundestag.1 The wild card in this election is the Alternative for Germany Party; the right-wing, anti-immigrant, anti-Islam, Eurosceptic party. It has done surprisingly well in Germany’s state and local elections and is up to 13 percent support. It could gain more support if opposition to Merkel’s migrant policy grows. If the unthinkable happens and Merkel loses, the E.U. could be in big trouble, with significant negative consequences for the euro.
Central Bank meetings may stimulate further fluctuationsCentral Bank policy meetings can also deliver surprises either by way of unexpected changes to official interest rates or subtle changes to policy language that may in turn reveal how the relevant central bank is thinking about current economic conditions and its future response. These meetings are closely watched by professional market participants as they have the ability to move the dial in currency markets. Included below is a table of key central bank meeting dates for reference along with a description of the current issues facing a number of relevant central banks.
Reserve Bank of Australia (RBA)
The Reserve Bank of Australia (RBA) sets the AUD official cash rate target on the first Tuesday of every month, except January. Many economists expect the RBA to hold rates steady at 1.5% for the remainder of the year. The RBA itself, however, is keeping a keen eye on the value of the AUD relative to its peers (it wants the AUD lower to sustain export competitiveness). The catch is: continued growth in home prices in Sydney and Melbourne would constrain any move to cut rates as the RBA would be reluctant to provide any additional stimulus that may further inflate property prices.
Federal Open Market Committee (FOMC)
The FOMC meets eight times each year. The Fed has previously announced that it will be increasing USD interest rates incrementally over the course of this year, subject to these moves being supported by strong underlying economic data. The risk to the program of interest rate rises lies in weak inflation and employment data and an ensuing reluctance on behalf of the Fed to raise rates as outlined and this could have a negative impact on the USD.
European Central Bank (ECB)
The big decision for the ECB in 2017 will be how it manages to exit negative interest rates and reduce asset purchases. While the ECB claims its current accommodative policy stance has encouraged growth and inflation, there are those who would argue that growth would have been higher without them. If the ECB exits negative rates and ends asset purchases sooner than expected, it could send a signal to markets and send the euro higher against the USD despite all of the potential political risk outlined above.
Selected Central Bank Meeting Dates 2017
Managing Your Risk in 2017
In a nutshell, currency risk, which is commonly referred to as exchange-rate risk or foreign exchange exposure, arises from the change in price of one currency relative to another. Individuals and companies that have assets and business operations in foreign countries or simply have to make a future payment or transfer in another currency are exposed to currency risk as the value of foreign currency denominated cash flows will fluctuate in line with foreign exchange rates.
Companies like Apple, GE and BHP manage their foreign exchange risk in a variety of ways. The good news is that you don’t need to be a huge multinational to be able to hedge your currency risk. A number of the hedging strategies used in the professional market are available to individuals and small business owners.
While the potential for currency chaos in 2017 is substantial, it only takes a few simple steps to protect your assets. So take action today to keep more control over your money, and don’t let currency fluctuations take control of your future.