How the Strong U.S. Dollar Is Affecting Corporate Hedging

Treasury teams should be reconsidering aspects of their financial risk management programs in light of 2022’s dramatic increase in dollar strength.

This autumn, as the global economy grappled with the confluence of inflation, geopolitical uncertainty, and ongoing side effects of the pandemic, the U.S. dollar surged to a 20-year high. Over the past year, it has strengthened against the currencies of most geographies across the globe. The dollar did experience a period of weakness in the post-vaccine environment, as investors sought to take on risk, but 2022 saw an abrupt reversal in that approach.

Relative GDP growth, haven flows, and central bank activity have all played into the dollar’s strength. For corporations looking to mitigate their foreign exchange (FX) risk, a number of prevalent hedging themes have emerged.

 

Drivers of Dollar Strength

The exchange rate for any currency pair represents demand for one currency relative to demand for the other. That said, FX rates are equally shaped by the medium-term growth expectations between the two economies. Thus, one driver of the dollar’s strength this year has been the United States’ relatively strong growth rate when compared with other countries, even as recession fears loom.

‘Haven’ flows have also contributed to the dollar’s strength. During times of financial stress, investors often seek the safety of haven currencies. In the past, the U.S. dollar (USD), euro (EUR), and Japanese yen (JPY) have all been haven currencies, but in the wake of the Russian invasion of Ukraine, haven flows have moved away from the euro, given the Eurozone’s proximity to the war.

Notably, central bank activity in the face of global inflation has contributed to the dollar’s strength, as well. All else equal, if one central bank is hiking interest rates, that action will drive strength in the local currency. Among central banks around the world, the Federal Reserve has been the most hawkish, effectively leading its global peers with rate hikes. While the European Central Bank (ECB) is also following a tightening cycle, it communicated its plans later than the Fed did and, thus far, doesn’t look to be hiking as steeply. And when compared against the Bank of Japan (which has seen minimal inflation), the Federal Reserve is significantly more hawkish.

 

Local Currency Dynamics

In terms of specific markets, currency pairs in Europe have seen the most weakness against the dollar in 2022. (See Figure 1, below.) Specifically, the euro depreciated 16 percent against the dollar during the year that ended in September, while the British pound weakened 17 percent. Given the geographic proximity, the Russia-Ukraine war spurred the initial weakness in European currencies, as higher energy prices dimmed the economic outlook for the European region.

In a surprise to many market participants, the British pound also depreciated dramatically against the dollar after the UK’s announcement of tax cuts to support consumers facing inflation. The market’s view of the additional sovereign debt that would be needed was negative, leading to flight out of the pound.

Asian currencies have also weakened against the dollar; the yen fell a staggering 31 percent against the dollar from September 2021 to September 2022. The yen is even more isolated than its European peers, as the Bank of Japan is not looking to hike rates amid limited inflation in Japan. In China, the renminbi (CNY) has also weakened, driven in part by ongoing Covid lockdowns in Chinese cities and the government’s continued enforcement of its Zero Covid policy.

As an exception to the rule, the Canadian dollar (CAD) has wavered against the U.S. dollar, not changing dramatically over the past year, which reflects that currency’s strong correlation to oil and other commodity prices.

 

Hedging When the Dollar Is Strong

In many cases, given the sharp FX movements of the past six months, U.S.-based companies are seeing either large liabilities or large assets in their operations. Amidst these pressures, it is important to remember that the intent of currency-hedging programs is to minimize volatility in the P&L and create predictability.

Treasury and financial risk management teams should be prepared to field internal questions about FX volatility, and should have a plan to communicate the efficacy of the company’s hedging program. In many cases, enhanced management reporting and business intelligence tools can accomplish that task in a streamlined way. Such reports can consolidate exposures, summarize hedge performance, and provide hedging recommendations for decision-makers.

For corporate treasury teams looking to mitigate financial risks in the current market environment, three areas of prospective improvement may be worth exploring:

 

1. Hedging acquisition risks. Cross-border mergers and acquisitions (M&A) are a sensitive topic in the current environment. The length of due diligence has been growing, which means more FX risk between deal announcement and deal close. In many cases, companies are comparing the benefits and drawbacks of FX forwards and options along with deal-contingency provisions. Exploration around the ideal funding currency (e.g., funding an M&A transaction in dollars vs. euros) is also a common consideration in this environment, adding more complexity to M&A discussions.

Businesses considering cross-border M&A transactions right now should evaluate the likelihood that a wild currency swing will substantially change the economics of the deal. Those that want to reduce the risk have several alternatives, including:

 

2. Rethinking operational programs. The strong dollar and post-Covid environment are leading some companies to take a fresh look at their operations. Treasury and finance teams are comparing revenues with expenses for each currency the company does business in. What is the company’s overall exposure, after netting, in each currency? (See Figure 2, for example.)

In some organizations, this analysis may result in a reconsideration of which currencies certain sales or procurement deals should be transacted in. In other companies, this analysis may lead treasury managers to evaluate the interaction between rate-setting in the budgeting process and decision-making in the company’s hedging program.

 

3. Increasing stakeholders’ awareness of market volatility. Many forecasts for EUR-USD at parity have not happened to date. Thus, treasury groups should be careful to avoid relying too heavily on FX forecasts. Volatility is always a possibility; no one actually knows where currencies are going.

At the same time, treasury professionals need to take responsibility for educating others in the company about currency volatility and risk. Senior management and the board will likely have questions about FX movements and their impact on corporate financials. Treasury needs to anticipate these questions and have answers prepared in advance. Likewise, treasury and finance teams should revisit their plan to communicate about FX volatility—and its impact on corporate performance metrics—to all stakeholders, including investors, employees, and banking partners.

 

See also:

Kevin Jones leads Chatham’s Corporate Hedging Advisory team, where he serves corporate clients in interest rate and foreign currency hedging advisory. Jones’ expertise spans risk quantification and analysis, hedging strategy development, market dynamics, and trade execution. Prior to Chatham, Kevin worked at the Federal Reserve Bank of New York, where he specialized in foreign central bank FX reserve and Treasuries market activity.

Disclaimer: Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting, and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading adviser and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.

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