Sterling Pounded by Weak Growth and a Distressed Chancellor

This post will discuss the recent downgrade of the United Kingdom by Moody’s Investors Service, why the Bank of England may be ill-prepared to act, and why the Government’s refusal to act could keep the British economy, as well as the British Pound, in the gutter for 2013.

As the last week of February arrived, the British Pound found itself in a precarious position: it was the worst performing major currency in 2013. Yes, worse than the Canadian Dollar; yes, even worse than the Japanese Yen. Yes, the Japanese Yen! This is quite astounding, purely because the Bank of Japan and the Japanese government are working double-time to Yen in order to foster inflation, introducing significant stimulus on both the fiscal (new spending programs) and the monetary (doubling the inflation target and introducing an open-ended QE program to begin in January 2014) fronts, while the Bank of England appears to continue to sit on its hands.

Two central banks, moving in slightly different directions, and yet the more aggressively-dovish one doesn’t have the weaker currency. This truly emphasizes how weak the British economy is, and why it is likely that the British Pound remains weak, alongside its economy, for the rest of 2013.

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Growth has been modest at best, with the 4Q’12 GDP print only revised to +0.3% annualized the last week of February, helping the economy elude the difficult economic condition known as stagflation, or a period of economic conditions characterized by low or negative growth, high inflation, and high unemployment. These conditions were exacerbated by Chancellor of the Exchequer George Osborne’s austerity program, a choke on the British economy, which too is heavily dependent on consumption: higher taxes take a chunk out of that 64% of headline GDP figure.

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Ideally, in response to these conditions, the Bank of England would be acting. Instead, it seems unwilling to do so. The most recent policy meeting notes show that outgoing BoE Governor Mervyn King was outvoted trying to increase the central bank’s QE program by £25B. With outgoing Bank of Canada Governor/incoming BoE Governor Mark Carney talking up dovish central bank actions the past several months – going so far as to say that global central banks haven’t let “hit their limits”  – it appears a low rate environment is in store for the British economy, further undercutting the British Pound.

Indeed, these fiscal and monetary forces have provoked Moody’s Investors Service into downgrading the United Kingdom from its pristine ‘Aaa’ rating, to ‘Aa1,’ giving the U.K. a split rating just like the United States. In the near-term (remainder of 1Q’13), there may be few new negative catalysts that might present themselves, preventing the Sterling from getting pounded any further. But for the remainder of the year, as the economy gets worse amid steeper austerity conditions and a BoE that will be struggling to find its new identity, the British Pound could remain one of the weakest major currencies, next to the Japanese Yen. The GBPUSD should move towards 1.4250 by the end of 2013.

This series of eight posts will focus on the major themes affecting currency markets. The sixth post in this series will discuss the diminished economic outlook for the Euro-zone, and why the crisis hasn’t been truly resolved.


U.S. Fiscal Issues: Austerity Hits the World’s Largest Economy

This post will discuss the self-induced austerity measures U.S. politicians have manufactured, a major hurdle to the recovery in the world’s largest economy.

The U.S. economy is headed in the right direction thanks to stronger consumer confidence, and now the Federal Reserve is signaling that its policymakers feel that it may be soon to begin the process of draining liquidity from the financial system. But this could not come at a worse time. U.S. politicians remain dramatically partisan and refuse to cooperate on nearly anything; voting among party lines for every major vote in recent memory, seemingly if only to spite one another.


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The best manifestation of this division is best exemplified by the budget negotiations, which have pitted Democrats, in control of the White House and the upper legislative house (the Senate), against the Republicans, in control of the House of Representatives (the lower legislative house). The first such impacts of these cuts were seen in the 4Q’12, when the U.S. economy contracted by -0.1% annually. Why?

The swift -22.0% annualized cut in defense spending, the sharpest pace in a decade, alongside weak inventory growth and the trade deficit (when imports outpace exports), created a -2.7% annualized drag on the U.S. economy. This drag was just enough to offset the strong combined +2.6% annualized growth rate in consumption and private investment (further highlighting how much stronger the U.S. consumer is). This weak growth is noted on the graph above on the far right, where the 4Q’12 GDP figure is circled, with the notation “austerity,” the term meaning “a fiscal policy that entails reduced government spending and higher tax rates, with the purpose of eliminating a budget deficit.” Clearly, a further reduction in government spending – part of that -2.7% drag, best reflected by the steep drop in defense spending – is going to weigh on growth.

As the headlines surrounding the budget sequestration, as it is officially called, continue to flow. In total, $109B in cuts will be made over the course of 2013; however, this results in $85B in cuts on March 1 alone. This will be the beginning of $1.2T (T for trillion) in budget cuts from 2013 through 2021, unless new measures can be agreed upon.

If politicians do not address the budget sequestration right away, then any prolonged period of drain on the economy could negatively affect the U.S. Dollar. While any increased credit risk is likely to roil global markets just as it did in 2011, culminating in Standard & Poor’s downgrading the United States’ then-pristine rating from ‘AAA’ to ‘AA+,’ the weaker economy could alter the Federal Reserve’s exit plans. If it becomes clear that the Fed will have to reverse its recent rhetoric in order to keep liquidity provisions in place, recent gains seen by the U.S. Dollar could be unwound, as the economy suffers. While the U.S. Dollar is strong now and enjoys a potentially bright future, there are certainly concerns lingering; political division in the United States could be the straw that breaks the U.S. economy’s and the U.S. Dollar’s back in the 2H’13.

This series of eight posts will focus on the major themes affecting currency markets. The fifth post in this series will discuss the recently berated British Pound and why the world’s oldest currency looks, well, old.

The Federal Reserve, the U.S. Economy, and the U.S. Dollar: Part 2

This post will discuss the broad ramifications of the Federal Reserve’s exit from the markets on the U.S. Dollar, and the process by which it will be accomplished.

While the S&P 500 climbed by +42.15% over the past three years (since the beginning of February 2010), the U.S. Dollar has been quite flat, yet volatility has been quite high. When QE2 took place from November 2010 through June 2011, the Fed’s total balance sheet size surged by $600B. It’s of no coincidence that during the lead up time to the initiation of the program to its culmination that the ICE Dollar Index, a weighted average of the ‘true’ value of the U.S. Dollar relative to a basket of currencies, fell by -16.38%.

More recently, the U.S. Dollar has exhibited signs of strength during periods at which the Federal Reserve stops injecting liquidity or withdraws from the system, but against a backdrop of significant uncertainty around the world, from growth in the United States and Asia, to political in Europe, and violent conflict across the Middle East. There is a case to suggest that the U.S. Dollar would have gained regardless of whether the Federal Reserve was easing at such a torrid pace, but we think it would be even stronger.

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If the Federal Reserve begins to wind-down its QE3 program, it will likely be in a few steps: first, publicly discuss exit plans (happening now); second, slow the pace of asset purchases from its current rate at $85B/month to $0/month over the course of several months (4Q’13); third, keep the balance sheet steady with interest rates near zero percent (ZIRP) (through 1H’14); and fourth, begin to sterilize (sell the assets) the balance sheet (2H’14 through 2H’16). As this process occurs, because market participants usually front-run policy and act on rhetoric rather than actual policy more recently, the U.S. Dollar is expected to continue its upturn despite the continued expansion of the Fed’s total balance sheet, as it’s clear the stronger U.S. consumer is beginning to support a stronger economic recovery.

There’s a big “if” to this whole equation: the U.S. budget sequester. Yes, the pesky, self-induced dose of austerity that U.S. politicians agreed was the best way to fix the nation’s apparent deficit and debt problems. Could the feckless Congress derail the recovery?

This series of eight posts will focus on the major themes affecting currency markets. The fourth post in this series will discuss why political impasse in the United States could be the straw that breaks the economy’s and the U.S. Dollar’s back.

The Federal Reserve, the U.S. Economy, and the U.S. Dollar: Part 1

In the first post, we provided a broad overview of sentiment in the global investment ecosphere, from the perspective of a macro-focused investor – the type of market participant that could benefit by adding Hedgebook into their investing and hedging toolkit. The next two posts will focus on the monetary policies of the world’s largest economy, the United States.

In retrospect, 2012 was a good year for the United States: the economy had recovered from a mid-year lull in jobs growth, with the Unemployment Rate drop below 8% in the third quarter ahead of the presidential elections. While the jobs recovery has been rather meager, there have been some bright spots that are worth discussing as they have emerged as not only bright spots, but strengthening trends that could one day soon force the Federal Reserve to exit the market.

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In the chart above, we highlight the U.S. Advance Retail Sales report amid the Change in Nonfarm Payrolls report for a very specific reason: nearly three-quarters of the world’s largest economy is driven by consumption; the Advance Retail Sales report is the best proxy data available. It’s very evident from the chart above that consumption trends have been leading employment – it led the upswing in jobs growth in early-2010, and once again in mid-2010, while the turn lower in mid-to-late-2011 was led by softer consumption once more. Needless to say, consumption is key for the U.S. economy to continue to grow.

The big question is: can consumption maintain the U.S. economy’s slow recovery? The evidence is there: consumer sentiment readings are near in at multi-month and multi-year highs; wages adjusted for inflation are increasing, meaning that workers have more money in their pocket; the savings rate among households is increasing; and the housing market is showing greater signs of recovery every single month.

We do believe that the U.S. economy will continue to trudge forward this year, albeit at a slow pace, in no small thanks to the Congress in place, whose lower house is always at odds with the Obama administration. Near-term budget cuts will weigh on growth, as they already have in the 4Q’12 (this will be covered in the next post). Assuming that politics don’t get in the way of economic growth, it’s very possible the Federal Reserve sticks to its recent rhetoric, and begins to wind-down its QE3 program at the end of the year. If the economy is strong enough, markets could withstand the liquidity drain. If there’s one instrument that could benefit from a smaller Fed balance sheet, it’s the U.S. Dollar.

This series of eight posts will focus on the major themes affecting currency markets. The third post in this series will continue to discuss the Federal Reserve and the U.S. Dollar.

Will Central Banks Keep Easing?

As the calendar turned to 2013, all was seemingly well: Chinese “hard landing” concerns eased substantially, with growth settling near +8% annualized; the Bank of Japan’s new ultra-dovish mandate under the eye of new Prime Minister Shinzo Abe was sending the Japanese Yen plummeting, reviving the carry trade; peripheral European sovereign yields remained low and relatively compressed to their German equivalents, allowing the Euro to outperform every major currency; and U.S. politicians struck an eleventh-hour deal to avoid the fiscal cliff, the self-induced austerity measures intended to quickly cut the budget deficit.

But those were only near-term developments, 2012, like 2011, was marked by substantial volatility across asset classes, all thanks in part to unstable and unpredictable political issues in Europe. And yet here we are, in mid-February, with equity market in the United States nearing all-time highs, and (gasp!) there’s even talk about the Federal Reserve winding down its stimulus program later this year. With uncertainty so prevalent over the past several years, it’s quite miraculous where global markets actual stand; but it’s also clear that there must be another force at play.

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This exogenous factor, that seemingly has elevated the mood of all market participants, has been the additional liquidity provided by the world’s major central banks, in programs most commonly executed as a variation of quantitative easing, or QE. This process entails central banks increasing the money supply of their currency, for two main purposes: to lend to banks at ultra-low rates to incentivize them to lend the borrowed funds back to consumers and businesses, to help foster economic growth; and to weaken the domestic currency to help improve the competitive export position – a weaker domestic currency makes domestic products cheaper for foreigners. While this second point may be true, the first point, not as much; instead, much of the cheap liquidity has been the ammunition market participants need to partake in risky financial activities, which has sent the S&P 500 on its way to all-time highs.

Certainly, there is some clout to this argument. Over the past three years (since the first week of February 2010), the S&P 500 has rallied by +42.15%, while the major global central banks’ balance sheets (the Federal Reserve, the Bank of Japan, the European Central Bank, the Bank of England, and the People’s Bank of China) have increased by +38.42%. There’s a simple inference: only +3.74% over the past three years in the S&P 500 can be attributed to ‘organic’ economic growth, as the rest has been fueled by ultra-loose monetary policies being implemented across the globe.

But as we said to begin this post, 2013 began on a high note; many of the concerns plaguing the investing environment were resolved or swept under the rug, out of sight, out of mind. As the globe’s major economies improve, central banks will begin to drain out the excess liquidity in the system. Is the global market stable enough to withstand such a series of events?

This series of eight posts will focus on the major themes affecting currency markets. The next two posts in this series will focus on the United States’ monetary and fiscal policies, and how they could upend a slow economic recovery.

Why Timing is Key for Hedging!

Just like everything else in life – from barbequing, to merging into traffic, to releasing new products during certain economic cycles – timing is absolutely crucial in hedging foreign exchange exposure. The best way to know when to hedge or not is by looking at a chart – yes, it’s that simple!

Take the NZDUSD pair from January 2003 to December 2009:

NZD/USD Spot Rate

In April 2005, the NZDUSD moved to new all-time highs, having broken the previous one set over a year earlier. At this time, it wouldn’t have been wise to hedge against further new highs; but taking on a hedge for a downside risk would have been reasonable. The same can be said about the NZDUSD in January 2009 – it had moved to its lowest exchange rate in over six-years – it might not have been appropriate to hedge against further downside risks, but instead more proper to hedge against upside risks (hindsight being 20/20, this would have been a wise idea).

For example, in January 2008, it would have been a good time for a New Zealand company hedge payments made in U.S. Dollars, because were the NZDUSD to depreciate in value, the more money the firm would have to pay. If in January 2008, the New Zealand company decided not to hedge US$10 million in payments due a year later, it would have seen its cost rise from N$12.5 million (NZDUSD = 0.8000) to N$20 million (NZDUSD = 0.5000). By not hedging, the New Zealand firm would have had to pay out an extra N$7.5 million!

The next blog post will illustrate how market positioning can be used in timing.

Hedging, and a deeper look into the types of Financial Hedges

One of the popular misnomers about hedging is that it is a costly, time-consuming, complicated process. This is not true!

At the end of the day, there are two different types of hedges: natural hedging and financial hedging. It is not uncommon for companies to use one or both methods to implement their hedging strategies in order to protect their bottom line from currency risk.

Natural hedging involves reducing the difference between receipts and payments in the foreign currency. For example, a New Zealand firm exports to Australia and forecasts that it will receive A$10 million over the next year. Over this period, it expects to make several payments totaling A$3 million; the New Zealand firm’s expected exposure to the Australian Dollar is A$7 million. By implementing natural hedging techniques, the New Zealand firm borrows A$3 million, while subsequently increasing acquisition of materials from Australian suppliers by A$3 million. Now, the New Zealand firm’s exposure is only A$1 million. If the New Zealand firm wanted to eliminate nearly all transaction costs, it could open up production in Australia entirely.

Financial hedging involves buying and selling foreign exchange instruments that are dealt by banks and foreign exchange brokers. There are three common types of instruments used: forward contracts, currency options, and currency swaps.

Forward contracts allow firms to set the exchange rate at which it will buy or sell a specified amount of foreign currency in the future. For example, if a New Zealand firm expects to receive A$1 million in excess of what it forecasts to spend every quarter, it can enter a forward contract to sell these Australian Dollars, at a predetermined rate, every three-months. By offsetting the A$1 million with forward contracts every month, nearly all transaction costs are eliminated.

Currency options tend to be favorable for those firms without solidified plans, i.e., a company that is bidding on a contract. Currency options give a company the right, but not the obligation, to buy or sell currency in the future at a specified exchange rate and date. Upfront costs are common with currency options, which can deter small- and medium-sized firms, but the costs are for good reason: currency options allow firms to benefit from favorable exchange rate movement. Like interest rate swaps, whose lives can range from 2-years to beyond 10-years, currency swaps are a long-term hedging technique against interest rate risk, but unlike interest rate swaps, currency swaps also manage risk borne from exchange rate fluctuations.

Exchange rate volatility can affect a company’s hedging strategy – the next post will cover why timing is key.