USD: Are You Ready for a Sell-off?


The USD had a good year in 2018 by virtually all measures: the US Dollar Index (DXY) is up from the beginning of January by 5.7%, as compared to a depreciation of 10.4% in 2017; implied volatilities (using 1 yr EURUSD as a benchmark) are at a very subdued 7.7%, which compares to where it was at the beginning of 2017, at 10.5% ; the market continues to price in further hikes by the Fed, which continues to support the USD, and the Trump-imposed tax cuts gave the US economy a boost, again supporting the USD.

 

So all in all, a good news story. Or is it? 

 

We are beginning to hear rumblings from large market players that perhaps all is not so rosy for the USD on a forward looking basis: 

 

 

Why are these forecasters suddenly so glum?  Much of it has to do with a weakening global growth outlook, some point to elevated valuations in the US equity markets, which seem to be supported more by a market awash with cash than by solid commercial performance of corporate America, and still others are saying that recent US data is more reflective of the fleeting impact of Trump’s tax cuts, and not a proper measurement of the fundamental picture in the US.

 

While there are always opposing views, which makes the market behave efficiently (assuming you agree that the market is efficient, but that’s a discussion for another time) as supply and demand determine the level of prices of all assets, including the USD.  We at Validus are not yet of the opinion that the USD will weaken across the board in 2019.  However, this recent rhetoric got us to thinking that regardless of where you stand on the outlook for the USD, it is imperative as risk managers that we reflect on what the impact of a dramatic USD sell-off would be on our clients’ portfolio of investments, their current hedges, or their business in general.  We believe our clients should be contemplating this as well.

 

What if 2019 is a repeat of 2017, and we see a 10%+ depreciation of the USD?  For alternative asset managers, will this result in margin calls for your derivative hedges? For corporations, will you remain competitive if the USD sinks and your local currency becomes much stronger relative to the USD?  How will a cheaper USD impact your investments?

 

During periods of high levels of uncertainty typically we see an increase in the level of implied volatility in the FX markets, and a corresponding increase in the cost of FX options.  While we are certainly seeing an increase in uncertainty, as evidenced by the higher level of the VIX (the most widely used measure of US equity volatility index), we have yet to see this reflected in the FX market.  This gives risk managers the opportunity to add optionality to their hedging strategy at relatively cheap levels.  Whether you want to protect against the negative impact of a currency depreciation whilst retaining the ability to benefit from a move in your favour, or buying calls against your forward hedges in order to cap the liquidity impact of negative mark-to-market, now is the time to review your current approach to see whether there are adjustments to your strategy makes sense.  We have enjoyed a period of over 8 years of USD appreciation.  This won’t last forever, as the USD cycle tends to be 7-9 years long.

 

Chart 1: US Dollar Cycle (DXY)

 

 

Regardless of your outlook for the US Dollar, as the year comes to a close, now is the time to give some serious thought to how a significant depreciation of the US Dollar may have on your business, and whether you should consider altering your hedging approach to better position yourself in 2019.

 

 

Author: John Glover



 

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