Currency Pulse #25 - Treasurers and the USD Smile

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The dollar smile framework was proposed some years ago by FX markets analysts at US investment bank Morgan Stanley. The purpose of the framework is to explain episodes of USD strength during both ‘risk-off’ and ‘risk-on’ scenarios.

In between such episodes, the US currency tends to depreciate relative to other major currencies. Arguably, we find ourselves in mid-2024 on the broadly positive part of the strong USD phase, as AI-related innovation pushes up demand for US equities and the dollar.

The key question for treasurers is: what are their priorities at different moments of the USD Smile? And what is the role of FX management in that regard? Let us start with the left-hand side of the diagram—a strong USD in a ‘risk-off’ environment.

In risk-off scenarios, liquidity, cash management and counterparty risk tend to take centre stage. In the aftermath of COVID-19, a Deloitte survey found that 54% of CFOs saw liquidity risk management as the ‘critical’ priority for their treasury department. 

In that regard, Currency Management Automation provides a set of diverse solutions for hard-pressed CFOs and treasury managers: 

• Automated swap execution. API-enabled end-to-end traceability facilitates the adjustment of the firm’s hedging position to the ‘cash flow moment’ of the underlying commercial exposure [see].
• Conditional FX orders. Conditional orders allow treasurers to delay hedge execution, an especially useful solution when forward points are unfavourable. This optimises collateral management and creates more exposure netting opportunities.
• FX hedging programs. By removing FX risk, firms can reduce the credit risk in accounts receivables as they sell in their customers’ currencies. They can also benefit from extended paying terms when contracting in their suppliers’ currencies. 
• FX centralisation. While headquarters gain visibility and control over FX at the group level, they can extend 24/7 liquidity to subsidiaries—with customisable markups and validation rules based on tenor, amount, timing and currency pair.
• Multi-dealer platform connectivity. By mutualising/splitting the FX volume with different liquidity providers (LPs), counterparty risk is effectively managed. Counterparty risk within treasury is actively monitored by 83% of large companies.

Removing FX gains & losses, Part II

Our first blog summarised the arguments in favour of balance sheet hedging from a value-maximising perspective. In this second blog, we survey the problems derived from ‘time-based’ approaches, and from attempting to hedge every single transaction. 

Although very different in nature, these strategies present some pitfalls:

A. They do not ensure a clean, zero-line in terms of FX gains and losses

B. They may not be indicated in the event of unfavourable forward points

C. They may lead finance teams to neglect potentially risky exposures

Read the entire blog 👉 here.

Bi-weekly backtest: US exporter of medical instruments (*)

A US exporter of medical instruments sells $1.72bn in markets across several continents. Key export markets include: the Netherlands (31.4%), Mexico (18.7%), Brazil (14.2%), Germany (13.9%) and others. 

The company aims at reducing the impact of FX gains and losses on its P/L. Before testing our market-based solution against realised data, we uncovered many inefficiencies, largely on account of manual processes: 

• Time-lapse to risk mitigation. As the finance teams pull accumulated pieces of exposure from the ERP at arbitrarily set dates, there is an average of 16 days between the moment balance sheet items are recognised and the risk mitigation exercise.

• Spreadsheet risk. More than 35 spreadsheets are reconciled monthly, with a high risk of manual data input errors, copy-and-paste errors, formula and formatting errors, on top of key-person risk. Swap execution is also manually carried out.

• Unhedged exposure. Due to the heavy manual workload, 6 to 8 currencies are left unhedged. While the exposure to each of these currencies does not surpass 5% of the total, they are amongst the more volatile (BRL, PHP and ZAR).

There is also a heavy cost of carry as both the Mexican peso and Brazilian real trade at a forward discount to the dollar (6.24% and 3.48% respectively on one-year forwards). 

The proposed solution is a micro-hedging program for balance sheet items that uses conditional stop-loss (SL) and take-profit (TP) orders that allow small pieces of exposure known as entries to accumulate into larger positions. 

The new program eliminates the manual workload, provides full visibility and control over exposures, removes the risk of over/under-hedging from the finance team’s monthly forecasts, and reduces the impact of unfavourable forward points in USD-MXN and USD-BRL.

(*) Every two weeks, Currency Pulse presents a real-life case. No names are mentioned, absolute values and some details are changed. We use tools to backtest, with historical data and Monte Carlo simulations, our proposed automated hedging programs.

Danilo Gonzalez: “Out of Africa? No way!”

On Kantox's podcast, Agustin Mackinlay talks to Danilo Gonzalez, Treasury Manager for Europe and Africa at Siemens Energy. The discussion ranges from FX management centralisation to African currencies in the context of the energy transition.

“We focus on three main products: cash management, trade finance and probably the most challenging of all: FX management. No single day is like another. The challenges are totally different from one day to another.” — Danilo  Gonzalez 

The treasury team has managers allocated to one country for the three products, or sometimes a single person covers one specific product. This is the case for FX managers. Here are some of Mr. Gonzalez's main points:

1. A supporting role. Commercial project managers need support in tasks ranging from identifying the currency exposure to defining the right strategy and the right risk mitigation procedures.

2. Treasury centralisation. When you have over 400 commercial projects in different currencies, a degree of treasury centralisation becomes indispensable. It gives you the capacity to develop, enhance and adapt a single tool to many different contexts.

3. Different exposures. Product-business lines are hedged differently than projects involving turbines and power plants with long tenures (10 to 50 years). In project businesses, we don't need to think too much about FX forecasts. 

4. ZAR as a special currency. Within Africa, the South African rand is a special currency: it is more liquid than any other currency in the continent. There are some regulations, but you can hedge against Swedish krona, euros, etc. 

5. “Out of Africa? No way!”. There is talk of some multinational companies leaving the continent, as they are besieged by chronic currency instability. For Siemens Energy, as an energy company, “Africa is the right place to be.”

Watch the full episode 👉 here.

Mind the cliff

The ‘cliff’ is a popular term at Kantox. We use it to assess the effectiveness of layered hedging programs that reduce the variability of average hedge rates over time. A sobering paper analyses the use of USD in exports invoicing in the UK on the heels of successive FX ‘cliffs’ (*). 

“Relying on transaction‑level data on the universe of UK trade, we show that large foreign‑exchange movements can generate an aggregate transition in invoicing choices. This is driven by firms with low levels of operational hedging” — Bank of England

Key points:

1. Increasing USD invoicing in the UK. Following the GBP-USD 'cliff' after Brexit, UK exports have been partly dollarised. USD invoicing surged from 1/3 to nearly 55%, while the share of non-EU exports invoiced in GBP declined from 55% in 2015 to 35% in 2022.
2. Hedging and valuation. To avoid losses, previously unhedged firms (86% of the total before Brexit) sought to become "operationally hedged" by matching the denomination of their imports and exports. "More than 50% of extra-EU exports are now invoiced in USD".
3. Dollarisation. The UK economy is now more exposed to US and global spillovers. This dollarisation provides "an important counter to the de-dollarisation narrative that has taken ground [...] Further dollarisation is possible even outside emerging markets".

And just as the pound outperforms in currency markets, the degree of forward discount/premium to USD has all but vanished (0.04% in one-year forwards). Currency Management Automation, anyone?

(*) Marco Garofalo, Giovanni Rosso and Roger Vicquéry: "Dominant currency pricing transition", Staff Working Paper No. 1074, Bank of England, May 2024.

Five Useful Links

1. EACT Survey. The 2024 edition of the EACT Treasury Survey is out. The three top priorities are: (1) Long-term financing; (2) Cash flow forecasting; and (3) Capital structure. As always, a very informative read. We’ll discuss the survey from an FX management perspective in the next edition of Currency Pulse. 
2. Geopolitical risk. CompleXCountries—Global Treasury Intelligence is out with a commentary on geopolitical risk. It is “a major challenge for treasurers.” Some group treasurers do not rule out the possibility of “moving to invoice in hard currency to reduce FX risk, or moving to sell through marketers.”
3. BNPP on BNPL. The French bank BNP Paribas announces a partnership with Billie, a Berlin-based fintech whose BNPL (Buy-Now-Pay-Later) solutions allow business customers to purchase goods now and flexibly defer payment. The B2C-B2B convergence is going strong in the payments space. 
4. A Chinese perspective on RMB. A former PRBC official argues against an imminent depreciation of the Chinese currency: (1) The exchange rate is “both a relative price and an asset price", and China focuses on the real economy; (2) Far from indicating weakness, the interest rate differential —and the 2% to 3% “inflation differential”— are signs of stability. 
5. Mexico and the strong MXN. A Federal Reserve Bank of Dallas paper analyses the impact of the strong peso on Mexico’s growth. In Kantox’s view, Mexican companies have a unique opportunity to apply layered hedging programs to sustain their competitive position while profiting from the 6.25% interest rate spread between MXN and USD.

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