The risks we face by exposing ourselves to the vagaries of exchange rates are regularly underestimated. I have friends working for international organisations like the UN, the IAEA, or the EBRD who opted for a retirement pay in dollars. This looked very attractive at the time: when the euro was launched, it was worth 30 per cent less than today. Sadly for them, this is not the case anymore. Compounded by inflation, their pensions practically halved. More than a decade ago, when interest rates were still palpably high, many Europeans were nudged into low-interest mortgages denominated in Swiss francs. But in 2011, the Swiss currency jumped by 40 per cent in a matter of days and kept climbing since – a change which burdened borrowers with a windfall debt they could not afford. Many went bankrupt.
Our investments made in US dollars or other foreign currencies are exposed to the same risk. It is always surprising how the worth of our portfolio, be it shares, bonds or gold can fluctuate when measured against our home currency. A stronger dollar makes investments in US assets, be it bonds, shares or real estate more expensive, hence less attractive. A weaker dollar will dent the value of investments we have already made. Money put into emerging markets will be threatened by a strong dollar too as it becomes more difficult to service foreign currency loans, or to lure investors into fast-devaluing local assets.
It is therefore tempting to try to anticipate currency movements. Many people do so for a living. They are currency traders working for banks, as brokers for customers, or speculators on their own account. To change money is as old as human trade. Babylonians were as concerned as exporters are today on how to convert their revenue in foreign countries into something more meaningful at home, where cowry shells were usually less appreciated. We thus naively assume that trade flows, the export of goods and services, are at the root of currency evaluations. A country like the US, with a chronically negative trade balance – importing vastly more stuff than they export – would continuously weaken its currency as foreigners have to sell dollars to convert them into their home currency.
Just looking at the size of foreign exchange markets should make us rethink. Currencies worth seven trillion dollars change hands every day, 18 times more than world trade. Even when including direct investment flows, it is clear that forex trade dwarfs the actual need of exporters and manufacturers. Forex trade is highly speculative, guided by macroeconomic trends, momentum and reflexivity – our assumptions about the thinking of others.
Currency traders are typically young, don’t last long in their stressful jobs and don’t make much money on a continuous basis. It is estimated that only 15 per cent of all trades are profitable. Losses are typically realised at the end of a trading day. The biggest players in this zero-sum game – one’s losses are the other’s gains – are JP Morgan, Deutsche Bank, Citi Bank, XTX Markets and UBS acting on behalf of clients or for their own books.
Currencies worth seven trillion dollars change hands every day, 18 times more than world trade
Most trade has the US in mind. In almost 90 per cent of all trades, currencies like euros, yen, British pounds or, lately, crypto coins are measured and exchanged against US dollars. If one wished to buy a more exotic currency like the Malaysian ringitt, most banks would calculate exchange rates via the US currency. Note to self: this puts Maltese banks recently burdened by grey-listing at a disadvantage as dollar- clearing becomes more difficult.
Most professionals today are pessimistic about the dollar outlook. They point to the above-mentioned trade deficit and the United States’ speedily- growing budget deficit and argue their irresistible influence. Both deficits have to be balanced by foreign investors, who would like to be paid higher interest rates to compensate for America’s growing indebtedness. Yet asset purchases by the FED continue to keep interest rates locked. So the exchange rate would have to give. As I said above, when the dollar gets cheaper, all US assets become much more affordable, and hence more profitable, for foreign buyers. Money will keep flowing, even at unsatisfactorily low interest rates. The twin-deficit impact theory is so far only strong in theory. In practice, a currency can lose value only relative to others. For the dollar to sicken, other currencies would have to show rude health – at least in theory.
Following a very successful vaccination campaign and generous fiscal and monetary handouts, the US economy is at the moment roaring ahead of most other economies. Companies report record profits, unemployment is falling, the housing and stock markets are booming and even more important, bond and dividend yields are much higher than in other major economies. It is very difficult for any investor to be content with a gratification of minus 0.2 per cent for German Bunds, when treasuries yield plus 1.5 per cent. A widening inflation differential might change this calculus, but growth-related inflation may still look more enticing when compared to deflationary stagnation elsewhere. Others may catch up with the US, or even leave America in the rear mirror, but for now this does not look very likely.
And then there is the vexing phenomenon of the dollar ‘smile’. When things really turn sour, when markets tremble and fear spreads, the US currency and its sovereign bonds are traditionally considered a safe haven, no matter what.
The dollar is the world’s most preeminent currency and as the US can freely print greenbacks, it cannot go bust either – hence the dollar’s appeal as sanctuary. When the US subprime crisis triggered the Great Recession and doomed banks and sovereigns alike, investors sought shelter in dollar bonds.
Only under temperate circumstances, when the US economy is at a moderate disadvantage to others, the dollar will weaken. In extreme circumstances, for good or bad, it will rise.
For us retail investors who do not wish to forgo the yields and capital gains of US assets, exposure to potentially painful currency risk will ensue. As all hedging tools have fixed expiry dates, be it swaps or futures, we can never get the timing right. Our investments, typically lasting over ill-defined, long periods are not suited for techniques with firm sell-by dates. To neutralise currency movements impacting our portfolio, we should therefore spread investments over major currency blocks, while maintaining a firm euro footing. Over time, exchange rates will even out and we can keep smiling even when the dollar frowns.
The purpose of this column is to broaden readers’ general financial knowledge and it should not be interpreted as presenting investment advice, or advice on the buying and selling of financial products.
andreas.weitzer@timesofmalta.com
Andreas Weitzer, independent journalist based in Malta