By Jamie Jemmeson, trader at Global Reach Partners
The UK is a nation of traders, whether it be at the good old east end fruit and veg market, money and stock brokers or importers. As an island the UK has never been shy of international trade. However, as an island with its own currency the UK is vulnerable to movements in global exchange rates.
One of the problems the UK faces is that the US Dollar is king, the world’s reserve currency. In recent times we have seen reserves diversify as the Euro attempted to spoil the Dollar’s share. However, the European debt crisis has really put the cat among the pigeons causing many to question the viability of the single currency.
The net effect of this uncertainty over the Euro zone is that the Dollar continues to firmly hold onto its crown. Not only have reserves been reverted back into US Dollars to some degree, but the currency has also been bought as a safe haven asset. As the world premier trading currency, the movement of the dollar has a large influence on how Sterling and indeed global foreign exchange markets trade. For the UK in particular, the performance of the US Dollar can be crucial to both the import and the export sectors especially as many of the UK’s trading partners’ currencies may share a loose pegging (fixed level of exchange) with the Greenback.
Bad news and uncertainty appear to be on the agenda every week in Europe. However, investor sentiment has weathered the storm and is now more acclimatised to this flow of news and potential negative outcomes have been priced in. Markets are looking for opportunities to buy and there have been some positive signs for investors as German data remain steady. The European Central Bank has recently initiated their 3 year Long Term Refinancing Operation (LTRO), the take-up from banks totalled €529.5 billion.
It is hoped that this additional liquidity will find its way into the economy which, combined with an increase in risk sentiment, will result in a weaker US Dollar.
The other question being asked is whether the US recovery is really as robust as it looks? At face value, the US economy is on the path to recovery. However, despite the encouraging signs, unemployment still remains at elevated levels. As a result of this, along with continued uncertainty in the global economy, Federal Reserve members remain cautious, keeping the option of another round of quantitative easing (QE3) on the table. QE3 would mean in effect printing more US Dollars to buy up assets and increase liquidity into the markets to boost confidence. The net effect would be a weaker US Dollar by means of simple supply side economics.
The UK is over-reliant on its service sector, which in the good times was great. However, the stark reality is the economy is not balanced; this has been exposed during the global recession with the UK struggling to return to levels of sustainable growth. When the financial markets crashed, Sterling fell from the dizzy heights of $2.10 and €1.50 down to a low $1.35 and close to parity against the Euro.
So what effects will a weaker dollar have on the UK if the Federal Reserve were to the pull the trigger on QE3? For UK PLC, the effect will be mixed, both in the long and short term. As a net importer, there may well be benefits for the UK. Firstly, importing from US Dollar-dominated regions would become cheaper; this covers a wide range of products from oil and manufactured goods to food sources. Secondly in theory, due to the cheaper cost of importing, inflation should recede and in turn increase consumer spending and confidence. This could have a knock-on effect, stimulating the economy to grow.
One fundamental flaw that has been exposed is the unbalanced nature of the economy. If it were balanced it would have been in a much better place to deal with the recession. When Sterling dropped off a cliff, the manufacturing sector would have been able to pick up more business and replace some of the service sector job cuts. Instead, the government has had to address this imbalance with new initiatives to “Get Britain making things again”.
A weaker US Dollar could have a huge impact, as cheaper alternatives will be found and “Made in Britain” will once again take a back seat, promoting imbalance and damaging any longer-term strategy to face the next cycle of recession.
If the US decides they need to proceed with QE3, the Dollar will weaken, but should the US withstand the Euro crisis without taking such drastic measures, the Dollar will instead continue to strengthen. This leaves UK importers and exporters in a state of limbo in terms of whether to hedge or not.
Currency hedging needs careful consideration from both importers and exporters. The monetary policy of the US is simply beyond control. The only option is to be prepared for any outcome. Simply doing nothing could be detrimental and in some cases fatal for businesses. Protecting your budgeted currency rate is the most important objective, as this will remove some element of risk.
A forward trade can secure a fixed rate of exchange on a specified amount for a given time period. Another route to take is the use of currency options. Options allow the client to buy an insurance against the rate of exchange for the cost of a premium although, in some cases, no premium needs to be paid. Another choice could the exploration of new markets and currencies. In some of the more exotic regions (where the US Dollar is the accepted form of payment) you may find discounts for trading in the home currency.
The best advice for UK importers and exporters is to keep your options open and your wits about you, whether the US pushes the button on QE3 or not, the direction of the Dollar could still dramatically change. Whether it weakens or becomes stronger, there may well be a detrimental effect on the balance sheets of UK importers and exporters; we certainly haven’t ridden the storm out yet.
Join us on