Current Thinking

The Weak and The Strong-A Note on Exchange Rates and Currency

A blog by Frederic Slade, CFA, Director, Investments – September 1, 2014

A segment of the capital markets that often gets overlooked is the foreign exchange (FX) market, which trades in the US dollar, Euro, Japanese Yen, British Pound and over 60 other currencies. According to April 2014 data from the New York Federal Reserve, average daily volume in the FX market totaled over $800 trillion. Trading in these markets helps set the daily exchange rate between currencies. Most major currencies float freely in the FX market; an exception is the Chinese Renminbi (RMB), which is controlled by the Chinese government and not allowed to float.

To get a feel for exchange rates, let’s look at two currencies, the US Dollar ($) and the Euro (€). For this currency pair, the US Dollar is weak if we consistently need more dollars to get back Euros or, for every Euro, we get back consistently more US Dollars. On the other hand, the US Dollar is strong if we consistently need more Euros to get back US Dollars or, for every Euro, we consistently get back fewer US Dollars. Recent trends have shown a weak US Dollar versus the Euro: in July 2012, $1.20 was required to buy €1.00, while currently $1.34 is needed to buy €1.00. When the Euro was first introduced in 1998, $1.18 was required to purchase €1.00.

What are some of the financial impacts of exchange rates? Again, taking the US Dollar/Euro example, the table below shows a few simple comparisons:

I experienced the tourist effect recently on a visit to Europe, where the weak dollar added to the local cost of food and entertainment. However, looking from a different vantage point, a weak dollar can help US companies sell more goods and services since European consumers are more able to stretch their Euros. Another impact is the cost of labor to businesses. Companies doing the bulk of their business in Europe may be more likely to hire US workers if the dollar is weak. On the investment side, a US investor in European stocks and bonds ultimately has his or her investment translated back into US dollars, so a weak dollar will add to the return while a strong dollar will lower the return.

How much should an investor be concerned with the level and changes in exchange rates? Money managers have often noted that it is difficult, if not impossible, to accurately forecast exchange rates, because so many factors are involved (monetary policy, interest rates, flow of funds, etc). Hedging (preventing risk from currency rate moves through futures and options transactions) will have both direct costs, and possible opportunity costs if the currency being hedged weakens. Some experts have also argued that currencies themselves may add to diversification between and within asset classes since they may move in different directions from the underlying stocks or bonds. In short, unless exchange rate volatility creates discomfort, it may make sense for a US investor in an international portfolio to leave most or all of the currency impact as is.

Conclusion
The foreign exchange market is huge and exchange rates are constantly changing. When one party gains from a weak or strong currency, another party is adversely impacted. While it is important to understand the economic and financial impacts of currencies, the difficulty in predicting and/or actively managing exchange rates in a diversified international portfolio may suggest that it is better leaving currency impacts alone.

NOTE: Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Past performance is not a guarantee of future results.