On the back of the longest bull market in history, the first 91 days of 2020 posted the worst first-quarter losses ever recorded. The culprit: a novel coronavirus virus, which grew from a small cluster of cases in Wuhan, China to a global pandemic impacting nearly 200 countries and accounting for over 40,000 deaths. In January, the World Health Organization requested $675 million to support at-risk countries combating the public health emergency; by the end of March, the impact to global financial markets reached an estimated $10 trillion. Government initiatives ranged from travel bans and fiscal stimulus to martial law and nationalizing health-care systems. Central bank monetary responses have been more aligned: over 50 national authorities have cut lending rates since the end of January, most notably in the U.S. where the Federal Reserve slashed the fed funds rate by 150bps to a 0% target.
The speed of the disease and the scale of the responses have left global markets reeling, first from anticipated supply and demand disruptions and then by corrective “whiplash” as markets attempted to price in the impact of the responses. While 401Ks and gas-station prices provide tangible proof of this volatility to the consumer, corporations should closely monitor the less visible but equally ominous indicators in the foreign currency markets as the recent movements may very well have adverse impacts to consolidated earnings far beyond the first quarter of 2020.
Are currency markets broken?
Given recent foreign exchange rate movements, you may be tempted to ask, “are markets functioning properly?” Setting aside economies with statutory currency controls or hyperinflation, foreign exchange rates are fundamentally driven by supply and demand for the respective currencies as well as the relationship between deposit rates in the associated jurisdictions. In spot markets for example, a collapse in Chinese exports leading to a trade deficit with the U.S. would weaken the renminbi (CNY) against the U.S. dollar (USD), whereas Brexit negotiations that enable an outflow of British goods would likely strengthen the pound (GBP) against the euro (EUR). A 30-standard deviation (SD) jump in jobless claims in the U.S. might hint at an economic slowdown, thereby weakening the dollar, whereas a $2 trillion fiscal stimulus package might mitigate investor concerns and strengthen the currency relative to other nations.
Central banks also play an important role in determining exchange rates, in some cases by explicit design (such as the Peoples Bank of China) and in other cases as a by-product of their mandate (such as the Federal Reserve). Central banks establish the baseline for regional lending rates, which directly influences the return on deposits in those locales. When the Federal Reserve adjusts the target fed funds rate, the Bank of Canada and Banco de Mexico tend to adjust in step to avoid changes in value in the loonie (CAD) and the peso (MXN) relative to the dollar. These “synchronized” behaviors, if repeated consistently and for a sustained period, can lead to currency correlations among trading partners, within trading blocs or even with those intentionally excluded from them. While historical exchange rates and currency correlations hold no control over future behavior, market participants do consider past trends when pricing in the amount of risk present in both spot and forward exchange rates.
These risks, while generally less highlighted than those in equity or commodity markets, are similarly approaching the tails of what we have historically considered normal. As countries grapple with containing the infection rate, you should expect continued supply and demand shocks. Governments and central banks will likely continue their efforts to stabilize their respective economies, and these swings between shock and response will mean elevated levels of risk even in highly efficient foreign exchange markets. The question now should not be, “Are markets functioning properly?” but instead, “How could currency market conditions impact my organization?”
How could currency market conditions impact your organization?
Global currencies have fluctuated against the U.S. dollar over the past three months, from International Monetary Fund (IMF) reserve currencies to emerging market currencies. Many traditional safe-haven currencies, held in reserve by central banks and monetary authorities and viewed as being more stable, have touched nearly unprecedented levels. The euro fell well below a 1.10 exchange rate against the dollar (a -1.8 SD move) while the pound touched a 1.15 exchange rate (a -2.9 SD move). Canada and Australia’s currencies weakened far more against the dollar, with the loonie rising above a 1.45 exchange rate (a +4.1 SD move) and the Australian dollar (AUD) plummeting to below a 0.60 exchange rate (a -5.1 SD move). Even currencies that are commonly held as counter-cyclical, such as the Japanese yen (JPY) and Swiss franc (CHF), have experienced ~1 SD moves over a similar horizon. Emerging market currencies have predictably underperformed against the U.S. dollar, the Korean won (KRW) peaked above 1260 (a +2.5 SD move) and the Brazilian real (BRL) fixed above 5.18 (a +4.0 SD move) at the time of writing.
The rate and magnitude of these currency swings have fundamentally altered the volatility landscape. Traditionally, reserve currencies have ranged between 3% and 7% implied volatility on an annualized basis, with one exception being sterling (GBP) which post-Brexit has trended a bit higher in the 5% to 10% range. Emerging market currencies, such as the Russian ruble (RUB), South African rand (ZAR), and Brazilian real are predictably viewed as being riskier, with market implied volatility in the 8% to 15% range. “Pandemic economics” have re-written this script. Reserve currencies, prized for their stability, saw their 1-month implied volatility more than double (GBP, CNY, CHF) in the first quarter of 2020 with some tripling (EUR, CAD) or even quadrupling (JPY, AUD) at their highest point. Emerging market currencies saw volatility levels previously associated only with commodities: South African rand – 31%, Brazilian real – 32%, Indonesian rupee (IDR) – 33%. The average of the 1-month implied volatilities of IMF reserve currencies (EUR, JPY, CNY, CAD, AUD, CHF) against the USD is ~12.6% on an annualized basis at the time of writing; for comparison, the South African rand was at a “mere” 11.9% at the end of 2019.
A third layer of risk that is even less apparent but could have material impacts is the interconnected nature between currencies. Correlations are inherently backward looking but trade agreements can provide an indication of what the future flow of goods and services might be. The Taiwanese dollar’s (TWD) performance against the U.S. dollar has historically been positively correlated with the renminbi’s performance against the U.S. dollar, largely explainable by the flow of goods and services between them. How the euro performs against the dollar has historically been positively correlated with how the pound and Swiss franc perform against the dollar given the bilateral trading arrangements established under the European Union. The yen and the franc have often performed counter-cyclical to other global currencies and as such are frequently referred to as “risk-off” currencies. When stable, these relationships can provide natural offsets within an organization: exposure to euro revenue is partially mitigated by exposure to sterling expenses, remeasuring yen assets may reduce the exposure to remeasuring peso assets, etc. These offsets, however, depend on current and future behavior remaining consistent with past behavior. Border closures, supply-chain repositioning, and other COVID-19 secondary effects have already begun to disrupt the normal order. Over the past 91 days, many currencies (JPY, CHF, THB) have seen their correlations with others fundamentally shift, while others (EUR, GBP, CNY, RUB) have materially strengthened. Though flawed as it relates to currency markets, the axiom of “during a time of crisis correlations go to one” does hint at how the current pandemic is testing the limits of what we have historically viewed as possible.
Impact to financials
Currency conditions materialize in financial statements in a variety of ways with the most common indicators being consolidated EBITDA as well as the highly visible FX G/(L) line item. Weakening values of foreign-denominated revenues or strengthening values of foreign-denominated costs might be indiscernible from forecast erosions, while the revaluing of foreign monetary assets and liabilities can create highly visible swings in FX G/(L). Both manifestations can overshadow positive business performance, which is why many companies seek to eliminate this risk via hedging. However, hedging programs must be structured with current market conditions in mind. A public U.S. company had recently implemented a new hedging strategy designed to reduce risk to consolidated earnings to no more than $30 million USD on an annualized basis. Over the first quarter of this year, currency movements increased their risk to consolidated earnings net of hedging to almost $45 million USD. While forecasts had not changed, their unhedged positions created unanticipated and highly material margin erosion to earnings.
Your organization’s reactions to a given exchange rate will differ based on their your exposure to it, however your response to elevated volatility levels and correlation breakdowns should not. We are currently in a market where the euro of 2020 is more volatile than the rand of 2019, and where the yen is moving in sync with other southeast Asian currencies. No one can say how long these conditions will last, but your management team should not accept the premise that “we’re all in this together” and the only course of action is to wait and see. As you close-out the first quarter, your treasury team should proactively review your foreign exchange strategies and tactics and determine what steps you can take today to better position your organization going forward.
What can you do today?
On March 31, corporations around the world kicked off the retrospective process of preparing quarterly financials, and over the following weeks leadership teams will evaluate potential tactical changes and revisions to forward guidance. While currency shifts may have been less obvious intra-quarter versus contractions in sales or shifts in supply chains, the conditions described above will quickly move into the spotlight as balance sheets are remeasured and foreign earnings are consolidated. Proactive efforts in the following areas will better position your team to support the organization for challenges that lie ahead in 2020:
Evaluate whether exposures have changed.
Whether due to supply-chain repositioning or demand contraction, you should expect to see a shift in foreign business operations. This may even extend beyond the income statement: items such as prolonged vendor payment terms or delayed intercompany settlement processes may also impact the nature of foreign-denominated monetary assets or liabilities. Your team should maintain an accurate mapping of parent-level, foreign-denominated cash-flows as well as foreign-denominated balance-sheet exposures.
Review existing hedging
As exposures shift, you should carefully consider whether existing hedges are adequate. You should evaluate which currencies are hedged (or left unhedged), hedged via what instrument, and hedged to what ratio. Alignment with economic exposure is the first step but you must also ensure that the hedges will continue to receive preferred accounting treatment. Proactively identify hedges at risk of losing accounting treatment or those that are no longer economically required.
Quantify your inherent and residual risk. Understanding your exposures is the first step but applying market-based risk-modeling is the important step. As cash-flow and balance-sheet profiles shift, existing strategies will be stressed in ways not seen since the 2008 financial crisis. Stable exposures left unhedged will likely present material risk, historical hedge ratios may now provide only marginal risk-reduction, and legacy hedging instruments may no longer provide the appropriate trade-off between risk-off and downside participation. You should be able to quantitatively support either existing hedging strategies or proposed changes based on current market conditions.
Anticipate questions and provide guidance
Your team should anticipate fielding questions such as “should we be hedging this currency?” or “is my balance-sheet hedging program working?” or “are we at risk of losing hedge accounting?”. Proactively reviewing exposure changes, understanding the effectiveness (or riskiness) of existing hedges, and providing market-based recommendations will enable thorough and pre-emptive responses for your internal and external stakeholders. Your goal should be providing guidance, not waiting to field questions.
Chart an appropriate course
As corporations look back on the first quarter for any useful indicators going forward, the following cannot be understated: risk can be quantified. When facing uncertainty, is it is easy to think that proactive “what-if” initiatives hold less value, but this could not be further from the truth. When 2020 is in the rear-view mirror, organizations that successfully weathered the storm will attribute this to many factors. One key differentiator will be whether management teams took the opportunity to review existing hedging strategies and applied data-driven frameworks when deciding the appropriate course for the remainder of the year.
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Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with your organization’s objectives. Our full range of services includes risk management strategy development, risk quantification, exposure management (interest rate, currency and commodity), outsourced execution, technology solutions, and hedge accounting. We work with treasury teams to develop, evaluate and enhance their risk management programs and to articulate the costs and benefits of strategic decisions.
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Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 20-0110