Over the past few weeks, the latest Brexit developments have offered a litany of opportunities and threats to the market. Onlookers, from multinational companies to holidaymakers, are all watching intently for indicators in the currency markets that can help them make the right financial call.
Some are better able to do this than others and, in the FX business, we are arguably better-positioned than most. From SMEs to FTSE250 companies, the trading patterns of corporates can be a strong indication of the real economy.
Below, we’re sharing with you some of our proprietary trading data. It demonstrates one of the most interesting Brexit-related trends we’ve observed this year – the increasing reluctance of treasurers and finance directors amongst our corporate clients to ‘hedge their bets’ via forward contracts.
Taking the long view
Source & Copyright©2019 - Argentex
This graph shows the proportion of clients that have bought forward exchange contracts with us in recent years.
This is where a client ‘locks in’ the current exchange rate for a currency transaction that is to take place in the future. They are generally used for hedging, and the main benefit is the protection they offer corporate treasurers against price fluctuations. One would normally expect a higher proportion of forward contracts during periods of uncertainty and currency volatility, such as with Brexit.
However, as you can see from the above graph, we are seeing that the inverse is true. Despite overall volumes of total currency traded last year rocketing up by 28%, we find that the percentage of the volume that represents forward contracts fell to just 25%, compared to 42% in 2017. And the decline has continued – in 2019 year to date, only 20% of trades through Argentex are forward contracts. This is also the lowest proportion that our data has shown since we launched in 2011.
Source & Copyright©2019 - Argentex
Additionally, the above graph shows data on the average tenor of our clients’ forward contracts – essentially the length of time that the contract extends out to. This has declined from 153 days in 2017 to 125 days in 2018 and only 86 days in 2019 year to date – a fall of over 43% in just two years. This is indicative of treasurers feeling there is insufficient economic visibility to make a risk-free bet on the future.
In effect, not only are more companies electing not to hedge but, where they are hedging, they are doing so for shorter periods of time.
So, what’s going on here? Why does the data appear to contradict all precedents in the market?
We think there are a few interesting (and very human) elements misrepresenting and distorting the overall picture of the market.
Better safe than sorry
Firstly, we are of the view that many of the major investment banks and brokers putting out forecasts of 1.5200 and 1.5900 by year-end are painting an overly-optimistic picture of the outlook for pound sterling.
We see real and significant downside risks to Brexit’s eventual outcome, not least of which is the possibility of a Corbyn-led Labour government which we certainly don’t believe is priced in at present. Some experts argue that this risk presents a more threatening challenge for the value of the pound than No Deal – we don’t necessarily think that’s unjustified.
In relation to the above data, this makes sense. An optimistic market is one that doesn’t feel the need to hedge its bets, hence we see fewer forward contracts being purchased. But while this may be deflating the numbers, we caution that there is significant risk out there and corporate treasurers should be looking into forward contracts as a way of protecting themselves and their businesses. A glass half full may make more of a mess when spilt, than a half-empty one. In our view it really is a case of better safe than sorry.
Having a seat at the table – and using it
Secondly, there has been a trend over the last few years of corporate treasurers more frequently sitting at the board table and providing increasingly relied-upon advice to senior management.
When the referendum took place in 2016, most boardrooms were confident in their beliefs that we would stay in the EU. Old habits die hard, and this may well still be the case today.
With this increased influence comes a greater need for treasurers to be as active as possible. They need to fully understand the current political field and FX exposures, and price in the worst-case scenario – and it’s even more vital that they are able to communicate this in a way that allows senior management to make a sensible, informed decision based on facts and figures, not news headlines and personal opinion.
After making the wrong call in 2016, many corporate treasurers and financial directors are reluctant to put themselves in the same position again at the risk of further FX-related losses. In a departure from normal risk management convention, by trading on spot when a transaction needs to be done (the price on the day), treasurers are at the whim of the market, and they are currently in a state of ‘decision paralysis’ due to the extreme range of possible outcomes.
Additionally, corporate treasurers feel that the safest way to manage capital is usually by internal factors, rather than speculative bets when the spread of potential outcomes (both politically and economically) is so broad. They are turning to other, simpler, budget controls for safety.
Paralysis is the strongest form of speculation
In our view, forward contracts provide a cost-efficient way to mitigate all of the above. We advise our clients on how to develop FX solutions and, where concerns may be slightly exaggerated, we are experienced in explaining the ins-and-outs of what risk, if any, exists.
When done correctly, they allow UK corporates to significantly limit their downside risk and making the most of the potential upside. In our view, a treasurer not implementing an FX hedging or forwards strategy is the strongest possible form of speculation at this uncertain time.
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