GBP/USD Headed to 2.0!

[TheSundanceKid]

Interesting Article HIFX.

"Never short of an excuse to sensationalise a story financial journalists have recently been almost unanimous that the US Dollar will continue to slump taking Sterling back above the USD 2.0 level not seen since the ERM Deutschemark tracking days of the early 1990’s. Putting aside the obvious delight of the UK’s importers weekend New York shoppers families jetting off to Florida theme parks should the nation’s exporters of goods services be concerned? Is this all journalistic hype? Or is there a more fundamental change going on in the world’s currency markets?

Chart A


If we examine the most recent 10 years of GBP/USD rates 1993-2002 the range was USD 1.37 - 1.73 (chart A). Many Treasurers’ perception that the rate was simply fluctuating around USD 1.55 is born out by this statistic. During this period the range on any one year averaged 18 cents (12.3%) leaving anyone with GBP/USD exposure buyers sellers of US Dollars a substantial headache.
However if we go back further to look at the period 1973 – 1992 not only did GBP/USD trade in a substantially wider range USD 1.04 - 2.60 (chart B) but the average range in any one year leapt to 35 cents.

Chart B


Chart (C) illustrates clearly that in historic terms the GBP/USD rate has been in a period of relative hibernation in the past decade. A return to historic volatility would leave commercial currency exposure twice as important to those concerned potentially ruinous to those who neglect the issue.

Chart C


To put it in hard cash terms if GBP/USD were to rise 35 cents or 19% current levels a company selling USD 10 million back into Sterling could receive up to GBP900000 less than if rates stayed still. For companies with different levels of exposure as they say in the States you do the math.
The key questions are; is this level of volatility likely to return is the GBP/USD rate headed back above USD 2.0?
To answer these questions it is useful to ask what drives the foreign exchange markets what factors determine the rates why are the currencies so inherently volatile.
Economic text books might tell you the currency exchange rate between 2 countries is determined by the relative strength of the economies. The stronger economy with the most buoyant stock market might attract the most inflows abroad. The US economy during the Dot.com boom might be the best example of this. Funds flowed into the US Stock Market boosting the Dollar to ever higher levels particularly against the Euro. However post bubble although the stock markets have since fallen across the globe the US economy remains far healthier than the anaemic Eurol version yet the Euro has reversed its fall against the Dollar set new highs in recent months.
To further disprove the ‘relative strength of the economies theory’ consider the fall of Sterling against the Euro EUR1.75 to below EUR 1.40 over the 3 years to 2003 during which time the UK economy easily outshone Eurol. Further evidence can be found with almost every currency p post Bretton-Woods.
The current vogue is to blame the fall of the US Dollar on the massive US Trade Deficit running at over USD 40 billion per month. However further investigation reveals that the deficit was ‘at record levels’ ‘unprecedented’ for many years whilst the Dollar climbed steadily. The Japanese Yen provides another example of a rollercoaster performance of a currency whilst the trade account clocked up ever increasing surpluses. Shouldn't’t the Yen have been on a one way ticket to the stratosphere all the time?
Obviously the theory of economics is a much more complex picture than I paint here in the real world the currency exchange rates will be affected by a myriad of economic conditions. Attempts to combine all of these factors is often presented as a ‘f value’ or a ‘purchasing power parity’ for a particular currency p. One recent fly typical study suggested that both Sterling the Euro were approximately 20% over-valued against the Dollar. Does this mean the Dollar is about to climb substantially back to the f value suggested? Well it could but historical studies show that currencies often stray even further these theoretical values can remain out of kilter for years before swinging just as wildly back the other way.
It could be said that any combination of the economic theories or valuations will prove to be correct over time but in the commercial environment timing is everything. By the time the exchange rate matches the economically forecast rate your company could have gone out of business. In other words as a forecasting tool they are next to useless.
Of course we also know that Governments or their agents also attempt to manipulate their currencies. If we leave aside the pegs imposed on restricted capital flow currencies the track record of Governments of free floating currencies is very poor. Most economists acknowledge that intervention either monetary or verbal is futile in the end. The Bank of Engl will be pleased to confirm this privately.
So we have established that economic fundamentals offer very few clues as to the likely direction of exchange rates Governments would be well advised to keep their distance. We also know that exchange rate markets are incredibly volatile. Could this volatility be a clue to why economic analysis fails us?
The exceptional volatility can be easily explained by the nature of the participants in the Foreign Exchange markets. You might imagine that the massive increase in world trade since 1945 has created a market which sees a daily turnover of over USD 1.5 trillion per day. But whilst world trade was the catalyst it has been the growth of the speculator within global financial institutions that has transformed the foreign exchange market into the giant complex extremely volatile animal it is today.
If we go back to the economic text books again briefly the foreign exchange markets present an example of an almost perfect market. Cheap easy access perfect price information no real monopoly influence. The opportunity to speculate in such a market offered the early participants particularly the banks a useful additional source of revenue. However the lure of speculative profits quickly tempted any number of diverse financial institutions such as hedge funds pension funds mutual funds investment vehicles virtually every bank in the world to join the party. The result is that the business of the traditional commercial end user is swamped by the speculative activity. It is estimated that less than 3% of the market’s daily turnover is now based on commercial trade for goods services.
The result has been that the volatility which made the currency markets so attractive to the speculators has been fanned by the flow of new entrants the growth of sophisticated derivative products. These major financial institutions thrive on the daily volatility now spend millions just managing their increasingly complex foreign exchange risk.
The genuine end user importing or exporting goods services does not usually have the same resources to manage this type of volatility. Indeed in most cases the underlying business is complex risky enough without the added burden of exchange rate risk.
So where does this leave the average commercial user of foreign exchange? If we return to the example of a seller of US Dollars worried by the headlines in the weekend press our brief look at the historical context shows there is the potential for a return to both rates above USD 2.0 additional volatility in the coming months years.
Doing nothing is not an option. An adverse move in the exchange rate means that at best a company could find itself at a serious competitive disadvantage at worst out of business altogether. Remember we have established that exchange rates do not automatically return to their f value or their previous mean within a few years so most companies will not be able to ride out the foreign exchange pain. Of course a favourable currency move could result in a windfall profit but that is no reason to put the company’s hard earned conventional profits at risk.
The answer has to lie in a sensible risk management policy. The overall trend cannot be bucked but if an adverse trend can be identified hedging your currency risk can minimise the damaging effects preserving the competitive position in the underlying commercial market giving the business time to adjust to the new environment.
To identify the trends we need to turn back to the speculative market. Whilst it true to say that speculators may be using any number of the diverse economic indicators to make their investments in the market the majority are simply trying to identify which clearly established trend they should join in order to profit the continuation extension of that trend. Of course if enough speculators reach the same decision the trend extends anyway. This is the herd instinct in action.
The study of trends or human behaviour in any market is often distilled into the study of price movements charts so called technical analysis. It is this analysis which occupies the minds of much of the speculative market. By implication if a company has access to good technical analysis the trends in the foreign exchange markets may become a little clearer an appropriate hedging programme could be initiated.
it is not just the obvious long term trend for example current US Dollar weakness that needs to be identified. It is the quarterly monthly or even weekly trends - the normal ebbs flows or wave patterns - within larger trends which can provide opportunities to cover currency exposure. Timing is everything.
That is not to say that this is a perfect solution. Technical analysis is far fool-proof certainly not the self fulfilling prophecy some people assume. However it often gives some level of guidance when economic fundamental analysis continues to confound.
Even when you have a clearer idea of the forthcoming trend the key to a successful hedging policy is to think of it in terms of the probability of the currency forecast being correct managing the risk. If the worst happens is the company protected? Can the company afford to wait take advantage of the trend? Are we going to be disciplined enough to make the difficult decisions if the rate starts going against us?
Our Dollar seller should indeed be worried by the headlines but the very worst thing he should do is either panic or bury his head in the s. What he needs is some ht trend assessment an ongoing risk management policy some decisive action. No one can buck the trend in the market but by taking pre-emptive action you might just be in business long enough to be worried by the next sensational headline on a Sunday morning."

Bob Munro
HIFX PLC
17th March 2004