Corporate Currency Hedging 102 – The Best Hedge

Pyracantha – watch out for the pricks

Privet!

Or pyracantha if you don’t like your neighbourhood burglars.

Last time, we looked at exposure definition, in CORPORATE CURRENCY HEDGING 101 – WHAT IS AN EXPOSURE?.  Now, so let’s assume you have defined a transaction exposure and it is overseas sales in foreign currency, which needs to be hedged back into your home currency.

Your friendly banker is pushing you to buy put options, seductively telling you that the option will protect you if the overseas currency weakens, by giving you the right to sell it at an agreed price. But the best bit is that if the overseas currency strengthens, you are not obliged to sell it at that agreed price, you can sell at the actual spot price on the day.

Sounds tempting eh??? Heads you win, tails they lose. The only trouble is…….. you have to pay a premium to get into such an advantageous position. And the premium will be such that on average you lose……. not by much, hopefully. Why is this?

From a bank’s point of view, an option is more complicated to lay off or to manage – and so that extra input needs to be paid for.

The more cynical may look at it and see that an option has three inputs into its price;

  1. Spot price

  2. Forward price

  3. Volatility price

Each one of these has a spread involved – and as the customer you pay the spread. What is more, this complexity makes it much more difficult to obtain comparison prices….. and the bank knows that. Guess what tends to happen when the customer cannot compare prices being offered by bankers???? Yep, they tend not to be so hot (the prices, not the bankers).

So we recommend forward sales. The prices are transparent, and the bid/offer spread is as narrow as can be. So on average you will be flat in terms of P&L, but with the benefit of predictability in your cashflows and margins.

How Much?

Then there is the issue of how much of the exposure to hedge. Only you can decide that, and it will be determined by your objectives and the certainty of your exposure. If you are selling grain that you haven’t grown yet, you might not want to sell the full amount you expect, in case of a poor crop that year. This is a reason to sell less than your expected income, to avoid being over-hedged.

Also, you might want to consider your attitude to risk and regret. If you sell all your income forward, but then the currencies move in your favour, might you be beating yourself up for hedging away the benefit? This is another reason not to hedge the full amount.

Our Recommendation

In this scenario, we advise hedging with a 50% FORWARD HEDGE. That way, you have some protection if the market moves against you, but you enjoy some of the upside if it moves in your favour! Doesn’t that sound like an option, but without the premium and long-term expected loss?

 

PS. Can’t have a currency article without a chart – my inner-quant won’t let me.  So here is cable (GBPUSD) over 5 years.  Hasn’t it been range-bound for the last 12 months?  Despite all the Brexit news.  Damnit, I’ve mentioned the B-word. Sorry sorry sorry.

Cable has been quiet……
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Sterling Currency Forecasts. The World is More Important Than Brexit.

Market Screens are Green

Last month, back in those happy days when we believed Brexit would be sorted by the end of March – Yep, we were writing on 26 March – we made our GBP forecasts on the basis that No Deal would provoke a bit of a dip, whilst No Brexit would have a slight spike, but in either scenario, sterling would end up stronger against USD and EUR.

Jean-Baptist Alphonse Karr looking very Victorian

Jean-Baptiste Alphonse Karr said plus ça change, plus c’est la même chose.

Things have changed over the last 3 weeks – but still they are the same. We continue to not know what is happening with Brexit. We could be heading for a No Deal at the end of October, we could be getting Mrs May’s Deal approved (though it seems unlikely), or we could be having a new Tory PM and a bit of re-negotiation.

Whatever happens, we feel that the UK economy will continue to motor along okay, with investment decisions increasingly being taken anyway. Life goes on eh? The UK data seems to indicate that this is occurring, with strong employment and wages data, and quiet inflation.

US Non-Farm Payrolls were 196,000 in March, which matches our “decent level target” of 200,000. China seems to be stabilising its recent weakness. So it is only Europe skating on the thinnest of economic ice.

So whilst we see GBP strength still, it will not be as robust as we thought – until Brexit is fully resolved. Thus, in 6 months time, we see GBPUSD rising from today’s 1.30 to 1.38 (forecast down from 1.42). However, there is a serious risk of weakness in the EU area, so we still see EUR weaker against GBP. As last month, we expect EURGBP to fall from 0.8680 today down to 0.8200 in 6 months time regardless of the B-mess.

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Party Management is Killing Brexit Negotiations. No Deal is not Zero Probability.

What a bizarre sight. A Remainer is arguing for a harder Brexit, negotiating with a Leaver, who wants to effectively stay in the EU. It’s not easy being a politician is it? Poor old Theresa May doesn’t even believe in Brexit, but is trying to hold together a party which on the whole feels it should deliver it, whilst having a full spectrum from the ERG to Dominic Grieve. Meanwhile, even poorer and even older Jeremy Corbyn does want Brexit, but is trying to lead a party that is happy to oppose it.

Houses of No Decisions
Corbyn just before Brexit started

Clearly, the talks are just about the blame game, with both leaders wanting to avoid any backlash. In reality, the two positions are so close that a skinny fag-paper (which is an official engineering measure by the way) could not get between them. Which puts Jeremy Corbyn in a tough position. Having started the year by committing to oppose any Tory deal, now he needs to be seen to get meaningful changes in the talks. But Mrs May can’t give significant ground at this stage as it will split her party – which is of course the real reason he is there at all.

Corbyn in negotiation mode

And across the channel, where Merkel and Macron are to lose another day of their lives listening to British begging, perhaps it is dawning that imposing an impossible deal on the weak Mrs May could lead to an unpleasant outcome for EU.

Yet again we are begging for an extension, but the only credible justification Mrs May can offer is her own resignation – which will lead to a tougher scenario for the EU, as whoever follows is likely to be more antagonistic.

The City has decided that Brexit is not going to happen. In our view, the risk of the EU refusing a long deal is not negligible. They might give us only a month, just so that all sides can finalise their no-deal preparations. And leaving on Friday, although unlikely, is not impossible.

Given the City’s complacency, there is little upside on being long UK assets and GBP this next few days. A long delay is built into prices. If a quick deal or no-deal happens, expect a sharp move downwards.

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Corporate Currency Hedging 101 – What is an Exposure?

Egg-sucking. From bytesdaily

Apologies to all those Grandmas out there sucking eggs. Although, rather disappointingly, neither of my grandmothers bothered to teach me how to undertake such a venture. (See, a deprived childhood!)

However, we do know a bit about Currency Hedging for Corporates. And the starting point is to understand how your company’s bottom line could be affected by movements in currency markets. And that is the key to understanding a currency exposure. It might not be evidenced by an actual transaction in a foreign currency. Or it could be that a currency exchange should not be hedged.

It all comes back to clarification of the objective of your currency hedging. Are you attempting to;-

a) Ensure that this year’s budget is not disrupted by currency movements increasing costs, or reducing sales income?

b) Make sure that a competitor cannot price you out of a market due to exchange rate changes?

c) To avoid changes in the reported value of overseas assets?

d) To ensure overseas profits are translated at planned rates?

e) To keep your Treasury Team on their toes (yes, I have heard this justification)?

f) To make a bit of extra cash for the business

Clearly, where any of the above situations are critical to your business, then a hedge should be installed. Except e) which is unlikely to be critical… or f), which is just plain scary. But if any of those scenarios represent a tiny impact on your P&L, is it worth the hassle, expense and risk of currency hedges?

And what if you have 10% of your domestic market and your overseas competitor has 90%? Well firstly, you’re probably in more trouble than currency hedging can help. But think about the dynamics of market pricing. If your currency suddenly strengthens against theirs, your competitor can underprice you and decimate your sales. So you have a big exposure to their currency, even if you never even use it. Food for thought eh?

Or the converse held for a client of mine, who was exporting luxury goods from US to Mexico. They had very diligently (and expensively) been hedging forward their exposure to the Mexican Peso. But guess what happened when the Peso devalued by 25%? All of the luxury goods in Mexico – supplied by the client and their competitors – just went up in price by 25%. The USD value of sales remained unchanged.  Meanwhile, the hedge proved to be a great windfall – but in truth, there was no exposure there, despite all the currency transactions.

Finally, I want to remind readers of the Mitchells and Butler fiasco of 2008, where they lost £274mil on a hedge that suddenly became very expensive when the deal creating the exposure never happened. It is hard to comprehend how that Treasurer (who lost his job) and the Bank Executive (who didn’t lose his job, funny that) agreed to put such a risky strategy in place, given that the exposure was uncertain.

Take-Outs (For non-Americans, I mean learning points, not McDonalds)

  1. Before currency hedging, work out what your objective is.

  2. Ensure you understand where your exposure properly lies

  3. Know how likely the exposure is to undershoot, overshoot, or disappear altogether.

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It is Pound’s Thrilling and Tense Time. GBP to Rise Whatever Brexit We Get

What is happening to sterling? You’d think it would be thrashing around like an angry hornet stuck in a beehive hairdo.

EURGBP remains calm
GBPUSD Remains Calm

But it remains calm , as has done since last autumn. Under normal circumstances, GBP acts like a divorce-child, torn between Europe and the US. Sometimes it goes with the Euro, on other occasions it sticks with the US Dollar. And very infrequently, enough happens in UK for it to make a simultaneous move against both its “parents”.

So what is happening now? Are currency traders;-

a) woefully short-sighted and not interested in Brexit, as it won’t happen today or tomorrow?

b) utterly complacent about Brexit and not factoring it in the price at all?

c) estimating that the percentage chance of No-deal has not changed, and so the effect on GBP has not altered?

But here is a little heads-up!

Currencies do move on matters other than Brexit. Hard to believe isn’t it, but there are a whole range of different inputs into a currency price? You know, GBP did move up and down before Brexit – and it will continue to trade after Brexit has either died or been settled.

Since our last currency forecast on 5 February, “Cable To Go Higher On Brexit”, the Brexit debate has moved on a little, in that it now appears to be more binary – No Deal or No Brexit. More on this tomorrow (sorry).

The world economy has slowed too. US Non-Farm Payrolls (our fave number) were weak in February. Europe looks weak too, with German industry catching a cold from China. Let’s hope that doesn’t become Asian ‘Flu. Meanwhile, the UK economy continues to trundle along with record employment and flaccid inflation. Suddenly, that isn’t looking too bad.

Interest rate rises seem to be off the board in all main economies, with the chance of more QT in the Euro Zone.

So to the forecasts.

a) No-Deal Brexit is probably 20% in the price of GBP already. If it happens, then watch out for some weakness against USD in the short term, but strength once the media-highlighted logistics problems are resolved, the strong UK fundamentals come into play.

We see GBPUSD at 1.2800 in a month and at 1.4200 in 6 months under this scenario.

Against the EU, we think No Deal is nearly as bad as for Europe, and so the EUR will maintain its level with GBP on a one-month basis at 0.8600. Over 6 months, we seen GBP stronger against EUR, with EURGBP at 0.8200 in September.

b) No-Brexit (aka Long Delay) then we see the same forecast levels in 6 months (driven by fundamentals), of GBPUSD at 1.4200 and EURGBP at 0.8200, but with a step up (provoked by guess what) rather than a dip in the meantime.

 

PS. Well done if you liked our pounds shillings and pence pun in the title. No prizes for spotting it though.

Money!
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London Will Not Lose Its Financial Dominance after Brexit

We do not believe that Brexit will dethrone London from being Europe’s pre-eminent financial centre.

London at Night

Back in 2017, Xavier Rolet forecast that leaving the EU could cost 200,000 jobs in London. By January this year, Nomura had the number down to 10,000. Our expectation is that approximately 5,000 people will actually be re-located from London to a different EU city. According to the statista.com website, the total number of financial services workers in London is in the region of 350,000. Thus the change represents about 1.5%, which is substantially less than the normal annual fluctuation. And we believe that these jobs/people will likely trickle back over the next few years.

The reason is agglomeration economics. The EU would love to grab hold of such a high-earning industry – and to be able to closely control capital flows and investments. Their challenge in making it happen – which they will not meet – is partly that they want to control the industry, which frightens it away. The major hurdle though, is that their financial services are too dispersed – and national-competition is unlikely to let them pick one centre to develop.

London by Day

Of those people leaving London, many have gone to Dublin, but others have gone to Frankfurt, Luxembourg, or Milan. Following President Macron’s temptations, a few have even gone to Paris, despite the tax rates.

The aforementioned agglomeration economies result from having a high-concentration of an industry in one place. Lots of good employees are drawn there by the multitude of opportunities, giving a great pool of talent from which banks can choose. A wide array of support industries appear: everything from specialist lawyers and accountants, to top restaurants, schools and transport systems. Informal and formal communication methods encourage the spread of information and best practice. This productivity-by-concentration applies to London, but not to any other single city in Europe.

In time, we expect a passporting agreement will be struck with the EU – but from a position of strength. European banks, companies and individuals will need access to London’s financial markets just as much as London wants frictionless financial customers across Europe. EU intransigence could mean this takes many months or even years to happen – but happen it will. London will thrive and grow inside or outside of the EU.

Politicians like to think they are in charge – but in the long term, they can’t beat economics!

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Who Killed Systematic Currency Trading?

Suddenly, the universe of systematic currency traders seems distinctly empty! What has happened?

Like animal populations that suddenly are decimated, the culprits tend to be sudden changes to the habitat which takes away food sources. In the case of currency trading, the markets are suddenly and structurally different for a range of reasons which have all worked against Systematic Currency Trading.

The Central Banks have taken away the capacity of investment banks to undertake prop (proprietary) trading, and so dozens of banks taking positions from gut-feel are no longer affecting the market.

Dealing rooms that were packed with spot traders are now silent, with just the odd computer technician checking the machines. So the days of hundreds of institutions providing liquidity and super-sharp traders taking positions are over. The market is dominated by just a handful of super-banks, who are more likely to just transact customer-derived business rather than “punting the market”.

And then there are the “Algo” traders, where any anomalies in the market are traded away by super-fast computers. If you thought universities or Facebook are at the forefront of machine learning, think again. Currency market traders now delegate decision making to the cutting edge of self-taught AI computers.

The days of a few maths PhDs sat in a darkened room plotting trends on charts are long gone.

The FX world is quieter too, with much less volatility experienced than, say, 10 or 20 years ago. This gives less opportunity for profitable position taking.

That is not to say that the universe has totally disappeared. But the survivors are becoming fewer. I heard a rumour that of 80 Currency hedge-funds or CTAs just 4 years ago, now there are four!

Meanwhile, the combined hedging and position advisors, such as Record Currency Management, https://www.recordcm.com/ continue to focus as much on Currency Hedging as much as position taking for profit. Only the most sophisticated, operated by top-end mathematicians, such as Alder Capital, https://aldercapital.com/ can continue to thrive in this tough world.

Sure, trends do still exist in the markets – as long as humans are allowed to take some decisions, then markets will find momentum. This is especially true of currencies, where many of the market users are there unintentionally, transacting currency as a by-product of a totally different decision.

The trick going forward is to manage the risk of position taking, so that the largest noise-related losses are avoided whilst the directional signal hidden there in the noise is detected and acted upon.

Easy to say, but ever more difficult to achieve!

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Cable to go Higher on Brexit

Whatever happens on B-Day, 29 March, we see GBP/USD (Pounds Sterling against the US Dollar, or “Cable” in FX Trader lingo) much stronger.

Our house view remains that a fig-leaf deal will be brought in just in time to cover the embarrassment of a no-deal, but even in a no-deal scenario, there will be a relief rally that the uncertainty has ended. Any currency wobbles in the case of a no-deal outcome will only last a couple of weeks until everyone wakes up one day to spot that the sky remains in the heavens.

Alternatively, should a clear path to a Brexit trade deal be established, then we see GBP being marked higher as a result of raised confidence in the UK economy and sudden capital inflows to the UK equity market and direct foreign investment.

The other end of Cable is the USD of course. The US economy is doing just fine – as shown by the Non-Farm Payrolls last week. However, we see interest rate rises in the US coming more slowly than the market expects, which would be negative for the dollar. We don’t see much in the way of rate increases in the UK either, but interest rates are more likely to surprise on the upside in UK than in the US, which again would be positive for sterling.

Thus there exists one of those attractive asymmetrical risk/reward situations for Cable. In a worst case scenario it could go down by 5 big figures (down 5c per pound), but we see it 12 big figures higher. Having more upside than downside makes a long GBP position very tempting.

Our forecast is GBPUSD at 1.42 by the end of August 2019.

Oh, and for Liberal Democrat fans attracted by our “Cable to go Higher on Brexit” headline, Sir Vince has announced his retirement after Brexit. It is a racing certainty he will be elevated to the House of Lords. It seems that old politicians always are ennobled, presumably out of sympathy so that they can continue to use the subsidised bars and restaurants in Westminster, rather than getting under their wives’ feet as ordinary retired men are wont to do.

We look forward to reading about Lord Cable of Middle-Road.

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Does the US Yield Curve Forecast a Recession?

In a word NO! Last month, there was much excitable reflection among the Economic Chatterati as the US Yield Curve had become inverted, if only very slightly so. It was claimed that an inverted yield curve has been an exceptionally reliable forward indicator that a large recession is coming. This is in contrast to the UK Stock Market, which is said to have forecast 9 of the last 4 recessions. (Ha, I love that quote. Does anyone know the original source?)

So why is this inverted yield curve not indicating a recession now? Well there are two reasons. The first one is that – big breath, as I’m about to utter the 4 most expensive words in investing – THIS TIME IT’S DIFFERENT. And another big breath, as here come the second most expensive 6 words in investing. NO, REALLY THIS TIME IT’S DIFFERENT. Please note how I have managed to avoid the old joke about big breaths. This is 2019 after all.

The adjacent chart shows the US and UK yield curves as they were earlier this week (thank you yieldcurve.com).

 

An inverted yield curve – where short rates are higher than long ones – is appropriate in normal markets if a recession is coming, as in such circumstances Central Banks tend to cut overnight rates to stimulate spending. Thus investors want to lock in fixed rates now and this activity will push down long term rates.

However, the current markets are far from normal, strange as that may seem to anyone under the age of 30. Back in the pre-Great Recession days, a “normal” interest rate would have been between five and eight percent. Back in the 1970s and 1980s it was more like eight to fifteen percent. In fact, I well remember as a boy having my grandfather tell me that interest rates at anything other than 4% were an outrage. Gosh, it was fun being a kid in my family! So wherever one’s pointer to normal interest rates lies, having them at 0.5%, 0.75% or even -0.4% is not normal and produces distortions.

The present market is different because we are awash with cash and rather short of bonds in which to invest it, both as a consequence of years of QE. These two effects each tended to push up bond prices and depress long term rates. Also, having ultra-low short term rates has caused a few technical issues in terms of how much higher long term rates should be in raw percentage terms or as a proportion of short rates. For example, if UK base is 0.75% and 10 year rates are 1.3%, then the difference is only 0.55%, but related to 0.75%, then 0.55% represents a 73% increase. This is like having overnight rates at 10% and 10 year rates at 17.3%, which feels like a very steep slope. There is also an argument that we have a glut of savings at the moment, which is all the fault of the baby-bloomers, as usual.

So the overnight rates are ultra low, but expected to rise, and the long market has been distorted by Central Bank interference. I would humbly suggest that when the free-market is massively overloaded by Governments – or in this case Central Banks – in any circumstances, including bank rates, then they no longer reflect the crowd-views of all active participants that in normal times makes them so powerful.

And there is a second reason that I included above. This is that the inversion was only slight, and has unwound pretty quickly. Anyone who last month liquidated all their stock investments and sold their house, chattels and grandma to prepare for the forthcoming recession might be feeling just a little annoyed that this supposedly failsafe indicator has flipped back again to a positive slope!

Away from the political excitements of US/China trade, EU/Italy budgets and a little fuss over Brexit, economic wheels keep turning and the recession threat has receded.

The flashing red-light and klaxon alarms have been extinguished!

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