Inflation, Interest Rates and Currency Risk

Central Banks across the globe continue to fight against record inflation numbers, and for the first time since 2008, there’s significant focus on rising interest rates. April’s US inflation data signaled another increase to 8.5%, which is up another half basis point since March’s 7.9% which was already a 40-year high. With the war in Ukraine seemingly without a clear path to ceasefire, and continued concerns around COVID with Shanghai lockdown ongoing, expectations are that interest rates will continue to rise with some central banks already aggressively moving to raise rates in the hopes to curb inflation.

Inflation has reared its head across a variety of areas, but has largely been propelled by surges in food, gas, and housing costs, which hit 8.6%, 38%, and 4.7% highs respectively in March’s data. Central banks have long used interest rates to curb inflation as a rise in rates leads to higher borrowing costs, thereby discouraging consumer and business spending, consequently managing rising costs by decreasing demand.

Inflation and interest rates however also have ancillary effects that are less transparent in overall costs of good and services, and one of those is in the increased cost, or cost benefit of hedging currency risk.

Not all countries’ central banks have the same interest rates. Although most G7 countries are trending around 0.5-1%, some central banks have been far more aggressive. Mexico and Indonesia sit at 6.5%, India and China at 4% and 3.7% respectively, and Turkey with a whopping 14% interest rate. This is important when considering hedging as the currency with the higher yielding interest rate will be discounted as you extend the length of the contract versus a regular spot transaction.

Example 1

For example, I am a US business with a project that requires funding in Mexico. I know that in one year, the funding for the project comes due, which is 1M Mexican pesos. I know the interest rate in Mexico is 6.5%, whereby the US Federal Open Market Committee (FOMC or “Fed”) has a set rate of 0.5%. Even with the expectation of a 1.9% interest rate in the US by end of 2022, the peso is still heavily discounted and that comes as a benefit to me of nearly 7% over the spot rate if I lock in today’s rate for 12 months in the future with a forward hedge. It is to the US business’ benefit to lock in the US rate now with a forward contract vs. the rate expected at the end of year.:

• 1,000,000 MXN vs USD spot @ 20.04321 = $49,892.21 – Regular Spot Transaction cost
  

• 1,000,000 MXN vs USD spot @ 20.04321 + forward points of 1.4088 = 21.45201 / 1M MXN = 139,847 = $46,615.68 Forward Hedge for 12 months cost, which is clearly beneficial to our US-based business.

Example 2

In another example, we see a very different situation for our US business. In the below, I am a US business purchasing a 1M EUR piece of machinery from Germany. I know the lead time on that is 12 months to build and deliver, whereby funding is due at time of delivery. I may have a budgeted rate of 1.09 that I have set with the supplier, which I want to hedge to protect my cost margins. That comes with a steep cost however as the European Central Bank remains at 0% interest rates and is signaling no changes until December of 2022. Compare that to the expected 1.9% the FOMC is targeting, and we see that again, the currency with the higher interest rate is discounted in value, negatively impacting my USD purchasing power.

• 1,000,000 Eur vs USD @ 1.09 = $1,090,000 cost
  

• 1,000,000 Eur vs USD @ 1.09 + forward points of 0.0257 = 1.1157 /1M USD = $1,115,700 – Forward hedge for 12 months cost. In this example, the forward hedge comes with an increased cost, as the US dollar is discounted against the Euro.

The important thing is to be aware of how these regular changes in interest rates across the globe affect the bottom-line margin in your business. Taking time to understand exposure to currency risks where you may be entering new markets or using new suppliers, is a good way to curb any negative effects on your profitability. Setting a budgeted rate that is flexible within your buying cycle will equally be crucial when judging when and how to hedge against currency movements. With recent spikes in inflation not being quite as transitory as once thought, we can expect interest rates to continue to follow suit. Having a good strategy and foresight in this area can help mitigate currency risk, and allow you to put more money back where you want it, in your business.