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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.

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.

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.

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.

Managing this FX risk faced by importers and exporters all over the globe today is a three-step process: identify FX risk; develop a strategy; and utilized the proper instruments/strategies to hedge the risk.

Identify FX Risk

As explained in the previous blog post, the most common type of risk faced by firms is transaction risk. For a New Zealand exporting company paid in Australian Dollars, measuring FX risk entails determining how many Australian Dollars it expects to receive over the coming quarter (whatever the period of business may be), versus the money the New Zealand firm will need to make payments in Australian Dollars over the same period. Simply put, this difference is the amount that needs to be hedged.

Developing a Strategy

Developing a hedging strategy necessitates that the following questions be answered: when should FX exposure be hedged; what tools/instruments are available under the current circumstances; and how will the performance of the hedge be measured? Developing a strategy is contingent on where in the process a firm is (see flow chart below).

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Using the Proper Hedging Instrument

Implementing the proper hedging strategy involves a review of the company’s policies as well as the intentions of the hedge. Hedges can vary from something simple like purchasing the foreign currency, to more round about ways like purchasing commodities in the country where the company’s products are sold.

We will discuss different types of hedges – what the proper hedging instrument is – in the next post.

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