A year ago, we found ourselves in the middle of a hard lockdown. Uncertainty was at an all-time high and the markets reflected this investor uncertainty. It’s crazy to think that only a year ago the rand traded above the R19 level to the dollar as investors aggressively sought safety in the dollar. A year later the currency landscape, amongst many others, is a totally different picture. The rand reached a one year low of R14.14 versus the dollar this month. Such a drastic change over the course of a year certainly makes managing currency exposure interesting. I have recently received many queries from clients asking what the future will bring for the rand and other currencies. I unfortunately do not have a crystal ball to guide me on this nor do I believe anyone who claims to be able to predict short term movements in exchange rates.
When we look at the currency markets and how they will react, we look over the medium to long term. As mentioned, no one can predict short term movements. We consider the economic forces at play in the markets, how they are intertwined with one another, and if there is a change in one or more of these variables, how this is likely to affect the longer term value of the underlying currencies.
I truly believe that the only way to handle currency exposure is with a proper foreign exchange risk management policy, which considers all the unique aspects of your business and that is consistently applied over time.
That being said, the question for many remains, where to now? Let us consider the facts.
Fact 1. During the first quarter of this year U.S real GDP grew by around 5.4%. This was largely attributable to a massive fiscal stimulus and a quick vaccine rollout. In contrast, real GDP in the euro area, the UK, and Japan contracted.
See figure 1.
While economic momentum still favours the U.S in the second quarter, the gap with the euro area, UK and Japan is likely to narrow dramatically. Looking out to the third quarter, both the euro area and the UK are poised to grow faster than the U.S. Europe, in particular, should see much stronger growth in the second half of 2021 following a sluggish start to the vaccine rollout. See figure 2.
With stronger U.S growth relative to global growth the dollar has managed to remain firm against its counter parts. As this trend reverses, we should see the dollar lose momentum especially against those currencies which are more dependant on global growth.
Fact 2. Interest rate differentials (the difference in interest rates between two currencies) are not in favour of the dollar. Long-term yield differentials did rise in favour of the US in the first three months of the year, giving the dollar a lift. However, long-term differentials have since reversed course, which helps account for the dollar’s renewed weakness. The Federal Reserve (Fed) has remained dovish in its stance and has kept interest rates extremely low. At its most recent policy meeting in April the Fed reaffirmed its position on interest rates and asset purchases by leaving both unchanged.
Unemployment in the U.S is still down around 5% versus pre-pandemic levels. See Figure 3.
Any inflation overshoot is likely to be temporary and therefore unlikely to sufficiently warrant an interest rate increase. This is dollar bearish.
Fact 3. The dollar is expensive. The dollar is still currently 13% overvalued based on Purchasing Price Parity exchange rates. On the premise that exchange rates move towards their fair value over time, the dollar should weaken towards its fair value, and even trade at a discount to fair value. Strong equity inflows into the U.S this year have supported the dollar despite investors being net sellers of U.S Treasuries. As the growth dynamics rotate from the U.S to the rest of the world, non-U.S stock markets are likely to outperform. This could cause foreign equity inflows into the U.S to turn into outflows. The dollar would then need to weaken to make U.S stocks more attractive in foreign-currency terms. See Figure 4.
Fact 4. Cyclical currencies will perform well over the next twelve months. Currencies which react positively to global growth improvements (ie high beta) are likely to fare best. As global growth improves currencies like the South African rand, Mexican peso, Chilean peso, Brazilian real in the emerging market space are set to appreciate. In the developed economy sphere, the Swedish krona, Norwegian krone, and Australian and Canadian dollars are poised to appreciate the most.
In conclusion, I will simply repeat that the only way to handle currency volatility is with a proper foreign exchange risk management policy, that considers all the unique aspects of your business and is consistently applied over time.