Uncertainty is the Only Certainty

At LinealPay, we are often asked why we don’t produce a daily or weekly comment on what is happening in the currency markets.

Clients, likewise, often ask whether they should be selling one currency and buying another. We don’t like to make predictions.

The truth is that the only thing we can be certain of, as currency experts, is uncertainty and therefore we avoid making too many calls. Even the odds-on favorite for the 2.30 at Newmarket gets beaten by the 66-1 outsider on occasion.

The US Dollar [USD] is seen by most as the ‘safe haven’, with much of the World’s trade being denominated in USD. So, sense would dictate, over time, that the general principle of holding USD reserves, being long, would be reasonable. Does this protect you against currency fluctuations? Put simply, “No”. It depends entirely on your functional currency cashflows and the timing of when you need to ‘cash-out’. You never know when there is a black swan event lurking behind the curtains, or the Fed has failed to meet market expectation and raised interest rates at a lower rate than the market had predicted. Of course, the opposite also applies.

We can look at indicators and point to variances in central bank policies. The ECB currently is faced with the multiple challenges of rising inflation, low growth and the mis-match between sovereign debt servicing costs between the richer Northern European economies and the weaker Mediterranean countries. Raise interest rates too slowly and they fail to bring inflation under control in a reasonable timeline and inflation becomes endemic. Raise interest rates too quickly and they risk undermining the economies to the south and taking sovereign debt servicing costs in these economies to breaking point. Fears of another Greek economic crisis is never too far away from the ECB’s mind. Throw in the Ukraine conflict and over reliance on Russian energy and you can see the challenges that the ECB face.

So, we can point to economic weakness in the Eurozone but, weakness relative to what? The UK faces similar inflationary challenges currently, raise interest rates too quickly and chance strangling already weak economic growth. Raise too slowly and again you are faced, like the ECB, with the potential of inflation becoming endemic. Recession, slow growth or stagflation, the choice is yours. It is the poor and the average ‘Joe’ who suffer the most from inflation and the asset rich who become richer and widen the gap between the ‘haves and have nots’. That said, and much against the theme, don’t be surprised if we see a further 0.5% rise in interest rate in the UK come Thursday although consensus points to a 0.25%. I think that the latter is already priced in.

So, which economy is weaker, and which currency should we buy over the other? Perhaps the wise man looks for the ‘safe haven’.

The general principle in times of worldwide inflation is to look toward economies whose principal GDP is weighted heavily to commodity production. As inflation increase, commodity prices rise and these economies do well. So, currencies such as the Canadian Dollar, the Australian Dollar and in a normal political environment the Russian Ruble. But when do prices start to ease as the effect of interest rates rises in consumption-based economies start to take effect and reduce spending? How do these changes correspond with your functional cashflows?

Faced with these challenges, you are left with the simple question of whether to accept the risk and potential for gain or loss, or create certainty by locking in your future costs? At the end of the day, the simpler question could be, what is it my business does? Does it speculate in the currency markets or does it provide goods and services to others?

Currency fluctuations can have a material impact on trading profits of businesses that buy and sell internationally. Contracts agreed today are often not settled until 60 or 90 days hence. On the 14th March 2022 £1 was worth $1.30507, today the Pound trades at $1.22756, meaning that the cost of buying goods in USD has increased by just over 6% in three months. A company usually making a 35% gross margin, with 2/3rds of costs coming from USD denominated inputs would have seen their profit margin eroded by 1.4%. With many companies making operating profits of circa 5%, profits would have been reduced by roughly 28%. Explain that to your shareholders!

One way of creating certainty is to lock-in the current exchange rates by using hedging. By looking at your currency revenues and liabilities and buying contracts such as currency forwards businesses can mitigate risk and create certainty in an uncertain World. Pricing of sales can be controlled and margins and potential profits planned.

At LinealPay, we offer forward contracts up to 12 months hence.

If you’d like to know more about our services, please email us at [email protected] or call us on 0203 105 9278.

Our website contains a more detailed guide on how businesses can manage exchange rate risk. You can download the guide at https://www.linealpay.com/insights/