Over the past 20 months, the EUR/USD exchange rate has remained within an historically narrow range. Approximately 95% of the time, it traded between 1.05 and 1.11, as shown in the chart below.
However, EUR/USD now appears to have broken out of this range, and several factors suggest that we can expect increased volatility and uncertainty in financial markets, particularly in the EUR/USD exchange rate. What are these factors, and how can buyers and sellers of foreign currency best anticipate this movement?
Factors Driving Uncertainty and Volatility:
- Future Central Bank Policies: Following the recent speech by the Federal Reserve (Fed) Chairman Jerome Powell, the market has become even more convinced that the Fed will aggressively cut its policy rate in the coming years. Whether this will actually happen remains to be seen, as does the European Central Bank's (ECB) future actions. Changes in expectations regarding central bank policies will undoubtedly affect the EUR/USD exchange rate.
- U.S. Economy: Recent weaker employment figures have raised concerns about the health of the U.S. economy. However, the outlook is mixed, with both positive and negative signals. Since central banks are ‘data-dependent,’ economic data has a significant impact on the EUR/USD exchange rate.
- (Geo)political Uncertainty: The current global political climate is fraught with uncertainties, including the upcoming U.S. elections, the situations in Ukraine and the Middle East, and rising tensions between the U.S. and China. All these uncertainties heavily influence the EUR/USD exchange rate, with the USD often serving as a ‘safe haven.’
How to Manage This?
Given these risk factors and uncertainties, we’ve observed that many companies with currency exposure tend to impulsively opt for a standard FX Forward contract. This instrument locks in a future exchange rate, seemingly eliminating all uncertainties.
But is this always the best strategy? We don't think so. It’s important to approach currency risk not only from your own perspective but also considering what your competitors are doing. What if you’ve hedged your currency risk with a fixed rate using a forward contract, and the exchange rate moves favorably? You wouldn’t be able to benefit, while competitors who didn’t hedge or used different strategies might profit. These competitors could then lower their prices or increase their margins! To avoid this, consider alternative hedging instruments that cover the risk (with a worst-case rate) while still allowing you to benefit from favorable exchange rate movements.
Given the risk factors and uncertainties mentioned earlier, you might expect these alternative hedging instruments to be costly. Fortunately, this is not the case right now. There is currently a mismatch between the expected market turbulence and the pricing of various instruments. As a result, it is possible to obtain relatively inexpensive ‘insurance’ for currency risk, with good timing being essential. After all, you don’t want to buy fire insurance after your house has already burned down. In short, attractive hedging options are currently relatively cheap, while uncertainty is high!
To Conclude
If your company has been buying or selling foreign currencies in the same way (via forwards, spot transactions, or a combination) for a long time, this strategy might have suited the relatively calm currency market we’ve seen in the past. However, now is an excellent time to discuss the most suitable strategies for a more volatile currency market that lies ahead. We would love to engage in a conversation to understand how your risks arise, how your current methods and strategy operate, and where we believe improvements can be made.
For those who don’t know us yet, we have no financial interest in advising you on specific products or solutions. Unlike banks and brokers, we have no market positions, and you cannot buy or sell currencies through us. We are the only truly independent currency advisor in the Netherlands, with a 45-year track record. We provide advice, and you continue to execute your currency transactions as you do now, without needing to ‘switch’ providers. In addition to improving your strategy, we can also help you achieve better pricing with your bank or currency broker (meaning you’ll pay them less margin). These two elements (strategy and pricing) provide such substantial value for currency exposures exceeding EUR 8 million that we have had the privilege of advising hundreds of successful (family-owned) businesses for many years.
Feel free to contact us if you’d like to discuss your currency policy and explore the available options without any obligation. Call +31.30.8201220 or email us at [email protected].
P.S. Although this newsletter focuses on the euro-dollar pair, we provide advice on all currency pairs and risks.
Best regards,
ICC Consultants BV
Treasury Advisory Team
