By Frances Coppola
But although volatility was lower, many analysts were surprised by the direction of travel of some currency exchange rates. At the end of 2016, analysts forecast a stronger USD and weaker euro and Japanese yen in 2017. In fact, the reverse proved true: the USD trade-weighted exchange rate gradually fell against all currencies,5 while both the euro and the yen exchange rates strengthened as their economies improved.
The future path of exchange rates is no more certain now than it was at the end of 2016. Nonetheless, here are some key trends that businesses may wish to consider when deciding FX risk management strategies for 2018 and beyond.
Asset purchases (mostly U.S. Treasuries and agency mortgage-backed securities) made in three rounds of Quantitative Easing (QE) have inflated the Federal Reserve's balance sheet to $4.1 trillion. Until September 2017, the Fed maintained this size by purchasing additional assets to replace those that matured. But now, the Fed is allowing its balance sheet to shrink as assets mature.
As the Fed's asset base shrinks, so too do its liabilities. The liability side of the Fed's balance sheet consists of USD in circulation, mostly in the form of electronic bank reserves. When the Fed purchased assets as part of QE, it created additional USD to pay for them. That money went into international markets, where it has been oiling the wheels of international trade and investment for nearly 10 years. Copious USD liquidity in international markets helps to keep exchange rate volatility down, since it reassures investors that they can always obtain USD.
Copious dollar liquidity has also helped businesses to expand internationally, confident that they can always obtain USD funding. USD has now become the currency of choice for international settlement, and a growing number of international businesses are choosing to operate entirely in USD. Ready access to cheap dollars for funding is important to these businesses.
Low USD interest rates have encouraged businesses outside the U.S. to issue USD-denominated debt, or to use cross-currency funding strategies to take advantage of interest rate differences between the U.S. and other countries. Divergent monetary policies between central banks in recent years have encouraged businesses to fund in euros and swap into USD.
But as the Fed reduces the size of its balance sheet while continuing to raise interest rates, obtaining USD could become more expensive, particularly for businesses operating in the riskiest developing countries. Investors may demand higher interest rates for corporate debt, including dollar-denominated debt. Banks could become reluctant to lend to businesses trading in riskier areas of the world. And businesses may become reluctant to hold balances in local currencies. All of this adds up to a more uncertain outlook for exchange rates.
But even though warnings of more expensive USD funding due to the strong dollar at the end of 2016 did not come to pass, many analysts anticipate a return of exchange rate volatility in 2018 as the Fed is now actively reducing USD liquidity by reversing QE while simultaneously raising interest rates. There are signs that volatility may already be increasing for developing countries.6
Businesses could respond to more expensive and volatile USD by turning to alternative currencies. The euro and the Chinese yuan are possible contenders. Trade among EU countries is already predominately in euros, though external trade is still often in USD. And the International Monetary Fund's (IMF')s decision to include the yuan in its SDR basket was widely regarded as heralding a much more significant role for the yuan.7 As USD interest rates rise, the euro and yuan might be more widely used for international trade.
However, turning to other currencies might not wholly solve the problem of rising funding costs. The European Central Bank (ECB) is already beginning to tighten monetary policy,8 and as the Japanese economy improves, the Bank of Japan could also consider ending QE and possibly raising interest rates.9 Some analysts also warn that there is a risk of a debt crisis in China, which could create problems for businesses using the yuan for international trade.10
Individually, central banks are taking a slow and cautious approach to policy normalization, to avoid market disruption. However, combined monetary tightening by the world's major central banks could create a tighter international liquidity regime than we have seen for some years. This could mean higher exchange rate volatility and rising funding costs in all major currencies.11
For some businesses, particularly those working in countries where high exchange rate volatility is a persistent risk,12 cryptocurrencies could provide a useful alternative to settlement in USD. However, exchange rate volatility among cryptocurrencies can also be very high, and unless businesses wish to maintain cryptocurrency balances, FX risk is incurred at both ends of a transaction. Some analysts also warn that cryptocurrency prices, which have been rising sharply, could crash at any time.13 Meanwhile, there are now exchange-traded futures in some cryptocurrencies, which may offer businesses some protection from sharp price swings.14
Concurrent monetary policy tightening by the world's major central banks could signal more expensive funding for international businesses and higher exchange rate volatility in 2018. Over the longer term, more expensive USD funding may cause the euro and yuan to be more widely used in international trade, and there may also be an increased role for cryptocurrencies. Businesses may wish to consider both short-term exchange rate volatility and the longer-term outlook when evaluating FX risk management strategies.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Sterling implied volatility jumps to highest in almost a year,” Reuters; https://www.reuters.com/article/britain-sterling/sterling-implied-volatility-jumps-to-highest-in-almost-a-year-idUSL8N1J50XX
2. “USD trade-weighted index (broad),” FRED Economic Data; https://fred.stlouisfed.org/series/TWEXB
3. “A More Stable Australian Dollar Going Forward As Current Account Deficit Narrows,” Pound sterling live; https://www.poundsterlinglive.com/aud/6519-anz-australian-dollar-research
4. “Emerging market investors wary of taper talk,” Financial Times; https://www.ft.com/content/59d2bc0e-619b-11e7-8814-0ac7eb84e5f1
6. “Strains on emerging market currencies begin to build,” Financial Times; https://www.ft.com/content/b42306fc-c481-11e7-b2bb-322b2cb39656
7. “China’s Ambitious Plan To Make The Yuan The World’s Go-To Currency,” Bloomberg; https://www.bloomberg.com/graphics/2016-chinese-yuan/
8. “Challenges for Euro Area Monetary Policy in Early 2018,” Yves Mersch, European Central Bank; https://www.ecb.europa.eu/press/key/date/2017/html/ecb.sp171206.en.html
9. “For the Bank of Japan, a tightening squeeze,” Wall Street Journal; https://www.wsj.com/articles/for-the-bank-of-japan-a-tightening-squeeze-1481450977
10. “China’s Debt Surge May Increase Risk Of Financial Crisis,” Bloomberg; https://www.bloomberg.com/news/articles/2017-11-21/china-s-debt-surge-may-increase-risk-of-financial-crisis
11. “Central banks, trade and bubbles threaten the 2018 status quo,” Reuters; https://uk.reuters.com/article/uk-global-economy-outlook/central-banks-trade-and-bubbles-threaten-the-2018-status-quo-idUKKBN1ED1B6
12. “Venezuela exchange rate fluctuation sparks price surge,” Reuters; https://www.reuters.com/article/us-venezuela-economy-forex/venezuela-exchange-rate-fluctuation-sparks-price-surge-idUSKBN1AP2LM
13. “Bitcoin could hit $60,000 in 2018 but another crash is coming, says startup exec,” CNBC; https://www.cnbc.com/2017/12/26/bitcoin-price-in-2018-could-hit-60000-but-another-crash-is-coming.html
14. “Bitcoin futures launch on CME as cryptocurrency marches towards the mainstream,” Independent; http://www.independent.co.uk/news/business/news/bitcoin-futures-launch-cme-group-chicago-cryptocurrency-mainstream-trading-a8116656.html
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