The race to hike rates and pound volatility

In this guest article, OFX provides a run down of how a volatile market is impacting interest rates.

As major economies strain under cost of living pressures, central banks are getting more aggressive on interest rates.

The difference in interest rates from country to country, otherwise known as interest rate differential, has a high bearing on currency performance and volatility. Our OFXperts explain what this means for UK-based SMEs managing overseas payments and revenue.

OFX tracks economic data and FX market moves 24/7 (so you don’t have to).

Recent data tells the tale of surging inflation, with readings consistently outstripping analysts’ expectations.

March – US inflation 8.5% – 40 year high
April – UK inflation 9.0%
May – US interest rate increase to 1%
May – UK interest rate increases to 1%
May – Euro area inflation 8.1% – record high
May – ECB hold rates
June – US interest rates reach 1.75%
June – UK interest rates reach 1.25%
June – UK inflation 9.1% – 40 year high

Central banks take steps to hinder inflation

Central banks are moving rapidly to take the heat out of their economies. By altering interest rates central banks can impact spending and its effect on how much things cost.

Why interest rate changes drive FX volatility

Generally, a currency tends to appreciate relative to a peer as the gap between interest rates widens. As interest rates go up, investors buy holdings in the currency where the yield is higher, and the increase in demand sees the currency gain in value. On the other hand, as investors sell off lower-yielding currencies, the drop in demand decreases currency value.

USD Strength

On June 15, as the US Federal Reserve announced its highest rate increase in 30 years, the value of the pound dropped sharply against the US dollar. The next day, the Bank of England quickly followed suit, raising rates to the highest level in 13 years and signalling that more hikes are likely, leading to a rally for the pound.

What about the euro?

For the past 20 years the euro has been stronger than the USD and the currencies were last at parity in 2002.

The European Central Bank (ECB) kept interest rates unchanged in the first half of this year which means the gap between US and European interest rates widened. Its economy is more directly affected by the war in Ukraine, and, as a net energy importer, more susceptible to its growth prospects being hit by supply challenges. These conditions caused the euro to slide around 10% against the USD at its lowest points in the first half of the year.

Take control of FX with OFX

Whether you’re trading in pounds, euros, or dollars, it’s a volatile time for exchange rates. Shifts between the time you receive and pay an invoice can mean you’re paying more than you budgeted for. Or, if you’re an exporter receiving payments in foreign currency, the value of that revenue can change. And even small movements can make a big impact on your bottom line.

What is hedging?

Hedging is the process of protecting yourself from a future change in price. In foreign exchange, it works by taking a position that prevents you from losing out if the currency market moves against you. At OFX, we use Forward Contracts to ‘fix’ the rate available to you for an agreed amount for a period of time, say, up to one year. But there are things you need to be aware of when determining if hedging is right for your business.

Jake Trask, OFXpert since 2010, works with SMEs on managing currency risk every day. Here are some of his top tips.

Are your payments regular or ad hoc?

Jake Trask, one of our OFXperts, said: “Hedging is a strategy suited to a company that has a regular need to buy goods or services from overseas, rather than someone who buys on a very ad-hoc basis.” If your business buys ad-hoc, then you have more flexibility in the payments you make. So, locking yourself into a rate for a period of time prevents you from taking advantage of potential market movements in your favour.

Mr Trask said: “A business should look to hedge when it has finalised an order to buy goods or services and it needs to mitigate the foreign exchange risk in buying those goods or services. But you need to be sure that the vendor is definitely going to deliver on your contract. So, signing contracts is very important.”

If the vendor does not deliver, or you end up hedging based on an estimate of your foreign exchange needs in the future, then you have committed to buying an amount of currency at a locked-in rate, which could leave you with a considerable loss if the contract is not fulfilled.

Are you comfortable if you miss out on a better rate?

If you have chosen to use a Forward Contract to fix a rate, you need to accept that if currency market volatility worked to your advantage, you would still have to abide by that contract, said Mr Trask. “Companies should be happy to pay a fixed rate for the duration of a contract. Even if the market rate pushes higher, they are still obliged to complete the Forward Contract.”

What if you want the best of both worlds?

“Some clients will do a combination of hedging half their exposure and doing half at the ‘spot’ or ‘on the day’ rate to potentially take advantage of upticks in the rate.” The real benefit for companies who hedge in this way is that they have set currency costs for a period of time. It may mean losing out if currencies move in your favour, but you will also be reducing the risk of any costly surprises.

OFXpert tips

1. In volatile markets, it’s vital to stay in the loop on currency movements. Sign up to receive OFX daily currency updates.

2. If you don’t have time to follow FX markets, speak to someone who knows them inside out. Our OFXperts are available 24/7. Call: 0207 614 4195

3. Consider how rising inflation and interest rate hikes could impact currency in the months ahead. It could end up saving your business money