In various ways, global investor trust in the United States and particularly the US dollar (USD) is being challenged. Actions to date by the Trump administration impinge on the three pillars underpinning the primacy of the USD in global finance and its ongoing reserve currency hegemony. These are trade, international alliances and faith in US institutional structures.
Of the major developed currencies, the USD has been the worst-performing this year, unwinding previous years of outperformance. Regarding the USD outlook, the phrase “regime shift” is now being bandied about. While currencies can be notoriously difficult to predict, there is consensus building that the USD could face significantly more downside pressure. We concur.
Cyclical pressures
In addition to the structural headwinds now facing the USD, as investors question the direction of the United States, cyclical pressures are building.
While the market could well have moved past the period of peak anxiety around the US policy agenda, US economic headwinds are just beginning and the “R” word, or risk of recession, is being widely used. The chance of recession adds a cyclical dimension to USD risk in addition to the wider structural forces. Buying US assets has been a strong and winning trade over much of the past decade and just a small but consistent global asset allocation shift out of this trade could easily see further downside pressure for the USD.
An overt shift out of US dollars resulted in the New Zealand dollar (NZD) trading back above US60c in April. When talk of a US economic recession or global recession risk is rife, the NZD normally struggles to perform. However, in a regime shift, past relationships don’t necessarily apply. The strong recovery in the NZD through April came during a period of notable downgrades to the global growth outlook, as conveyed, for example, in the International Monetary Fund’s April economic update.
The heightened volatility has created a difficult environment for exporters with foreign currency receipts, and importers with foreign denominated costs. The NZD has traded in a wide range between US55c and US60c to the USD over the last month, meaning wild variations when converting foreign denominated exposures into NZD. Very simply, a lower NZD will generally benefit exporters who are paid in foreign currencies, while a higher NZD will generally benefit importers who pay suppliers in foreign currencies.
Fortunately for New Zealand companies, there are market strategies to manage this volatility and uncertainty. While not suitable in all cases, FX hedging solutions can be used to lock in a rate on a specified date in the future, or to allow risk managers to hedge currency risk, while maintaining full or limited participation in favourable FX moves.
In investor portfolios, the impact of the currency is an important consideration for both risk and return. According to BNZ’s most recent FX Hedging Report, which is a unique survey of the managed funds industry in New Zealand, fund managers have, on average, just under 60% of their assets overseas. The currency exposure created by these offshore assets is typically partly, if not largely, hedged, whereby the New Zealand fund manager will lock in a rate to sell the underlying foreign currency and buy New Zealand dollars on a future date.
‘Over-hedged’
At the peak of the recent market turmoil in early April, fund managers were quickly finding themselves “over-hedged” relative to their target. This was because, as global equity markets plunged, the value of their offshore assets declined sharply. To counter this value destruction, they would have needed to reduce their hedging by selling the NZD forward, putting further downward pressure on the currency. Then, when Trump announced the 90-day pause to reciprocal tariffs and markets rebounded, this dynamic reversed. This whipsawing behaviour in financial markets highlighted the challenging environment for portfolio managers.
Adding to the challenge, when the NZD is in steep decline, New Zealand fund managers also face the prospect of losses on their hedging contracts. If these losses are realised, then some fund managers could be forced to sell assets in order to fund those losses. This is one reason managers generally hold an allocation of highly liquid assets such as cash, as selling illiquid assets in highly volatile markets can be costly, if not infeasible within a short timeframe. The subsequent recovery in the NZD has seen currency hedges mostly move back “in-the-money” which, if realised, will supplement investment returns.
BNZ is active in the provision of solutions for New Zealand businesses and investors with exposures to fluctuating exchange rates. We have teams of financial markets professionals able to discuss and provide solutions to specific foreign exchange requirements.
The BNZ Currency Overlay Solutions Group is a specialist team that provides a low-cost opportunity for wholesale New Zealand investors wishing to remove, or reduce, the currency risk associated with foreign asset exposures. BNZ takes on the operational responsibility of currency management from investors, with a robust programme flexible enough to meet unique client requirements, while reducing transaction costs.
Financial markets have been volatile this year and conditions could remain choppy for some time yet, but businesses and investors can minimise risk with appropriate trading strategies.
While this article shouldn’t be considered financial advice (and we always recommend that clients seek their own independent financial advice), hedging foreign exchange risk may be a key part of your toolkit to smooth out fluctuations on returns and earnings.
● BNZ is an advertising sponsor of the Herald‘s Capital Markets and Investment report.
