Insight for Uncertain Times

April 2020

Currencies are reflections of our world. 

Their ups and downs are reactions to global events occurring every moment of the day. They mirror the broader dimensions of what’s happening in society, not just economic factors. In this way, they are the ultimate sentiment indicator, telling us what the future may bring for a country, region, or the world at large. 

Observing short-term currency shifts can be overwhelming, but insights come from noticing patterns over time. So why don’t we pay closer attention? Why doesn’t the media report on currencies as diligently as composite indexes like the S&P 500 or Dow Jones Industrial Average? 

Currency fluctuations matter to everyday life more than people realize – perhaps even more than changes in the stock market. With the intertwining of global supply chains, currencies affect the prices of everything, including our domestic purchases and investments. Their ups and downs influence your weekly grocery bill, the value of your home and the relative worth of your savings.

But most people have no understanding of how currencies work, or what their fluctuations may indicate. As the largest asset class in the world, currencies simply shouldn’t be such a complete mystery to the average person.

Understanding their role in our lives can give us information to navigate these unpredictable times we find ourselves in – insight we need now more than ever.

With the uncertainty and speed of change associated with climate change, demographic shifts and technology advancements, it’s become urgent to notice what currencies tell us.

With this backdrop, here are answers to seven big questions about currency.

1)   How do currency changes affect my everyday life?

Much of what we think of as domestic investing and buying is an illusion. Yes, you may buy a product from a local manufacturer, but where is their machinery built? Where do they buy supplies to create their goods? Even local businesses tend to have international partners in their supply chains. The prices of the local milk, grains, vegetables and meat you buy are all affected by currency rates. This is also true for your car, your computer and all kinds of everyday goods.

Take a close look at the prospectus for your mutual fund and consider that most or all of the domestic companies listed probably generate a significant portion of revenue abroad. For most S&P 500 companies – America’s biggest public companies – the majority of revenue comes from outside the country.

The reality is, your investment portfolio likely has significant foreign currency risk. This isn’t a conscious decision by fund managers, it’s just the nature of the world we live in.

Very little in our complex global economy is purely local, and because of this a major change in currency rates could affect your cost of living and retirement savings in the blink of an eye.

2)   Are currencies really a bigger deal than stocks?

Currencies are overwhelmingly the world’s largest asset class with $6.6 trillion USD traded daily in 2019, according to Bloomberg. Yes, daily. While most people incorrectly assume that the stock market is the biggest kid on the block, the truth is no other asset class comes close in size to what’s traded daily in the global currency markets.

3)   So, why don’t people pay attention to currencies?

People pay attention to the stock markets mostly because they are reasonably easy to understand. Every stock on a market has a single price, making it simple to aggregate the movements of those prices and understand how the overall market is doing at a given time. We know exactly what the value of Apple or Tesla shares are at any moment, and we can also easily track how Nasdaq is doing.

Stocks are valued in a straightforward way, anchored by easy-to-find facts like earnings, cash flow and dividends. 

The world of currencies is complex and surprisingly abstract. Your domestic currency doesn’t have a single price. It is always priced relative to other currencies. The U.S. dollar might be worth $1.35 compared to the Canadian dollar, and at the very same time it may worth $110 compared to the euro. In fact, the U.S. dollar has a unique price relative to every other currency in the world (of which there are approximately 200), with those relative prices fluctuating moment to moment. It’s enough to make your head spin.

Because of this complexity, it’s hard to nail down what changes in currency prices mean, particularly at a personal level. With your stock investments, you can check your statement to see if you made money because their value went up, or lost because their value dropped. There’s no financial statement that tells you how changes in currency prices affect your wealth this month, or your costs for that matter.

Currency rates aren’t anchored by specific metrics as stocks are. Instead, it comes down to how currency buyers feel about the economic outlook of one country compared to another at any given time. Buyers speculate about what is likely to happen with a country’s inflation and interest rates, as well as intangibles like politics and socioeconomics. It could be said that the pricing of currency is more art than science; more emotion than math.

4)   Why are currency prices so volatile?

The speculative nature of currency valuations makes them more volatile than stock prices – they experience more profound highs and lows. Conversion rates are particularly volatile for emerging economies.  

Currencies are highly susceptible to world affairs; bad news can easily send them into an overnight tailspin.

The most recent example of this is the coronavirus (COVID-19) crisis which has sent currencies around the world reeling as investors search for a safe haven. Venezuela’s current political crisis, Iceland’s 2009 financial crisis, the 2008 mortgage crisis, and 9/11 are examples of epochal events that were associated with currency crashes. 

5)   Who invests in currencies? 

Big institutions like central banks, hedge funds and investment firms are responsible for the majority of the world’s currency trading and greatly influence prices. 

If these institutions feel optimistic about the Thai baht or the Chilean peso, they can purchase enormous positions in one fell swoop, potentially causing dramatic rate shifts. 

Major players conduct their trading on an interlinked computer exchange known as the over-the-counter (OTC) market or through an exchange like the Chicago Mercantile Exchange (CME). 

6)   Really though, do I really need to care about currencies? 

Since the 1920s, both the U.S. and Canadian dollars have enjoyed long periods of great stability, allowing most of us to live out their lives barely giving currency a fleeting thought. We tend to consider currency rates only in specific moments, like when we travel abroad or make an international purchase. We don’t worry much about the potential for a currency nosedive. Truth be told, even most financial advisors in the U.S. and Canada only occasionally think about currency.

In particular, the U.S. dollar is the undisputed kingpin of the currency world. It is the standard by which all other currencies are measured. Close to 80 percent of all currency trades involve the U.S. dollar. The euro and Japanese yen represent the second and third most liquid currencies respectively.  

But now, everything is changing. Other economies are maturing. Climate change is unsettling previously stable economies. It’s no longer the case that defaulting to any particular currency is necessarily the safest bet. More and more, the name of the game is currency diversification.

7)   Can I protect myself from currency fluctuations?

You can and should protect yourself from currency fluctuations. 

The first step is to figure out how you’re at risk. Start with your investments. Most people are hesitant to roll up their sleeves, dig in and really understand their investment portfolios, but it’s not as intimidating as you think. 

Locate the lists of companies your mutual funds invest in and do a bit of digging to understand where their foreign revenue comes from and what international suppliers they use. You don’t need to be exhaustive but get curious about what’s really going on with your money. You might even ask the fund manager about the strategy for absorbing currency fluctuations.

Based on what you learn, consider diversifying your assets in three ways: currency exposure, time horizon and overall investment perspective. Although it may feel easier to default to one currency like the U.S. dollar, this might not be sensible from a risk-reward perspective.

Next, if you’re a business owner, figure out what percentage of your costs are in foreign currencies. If currency rates changed and suddenly those costs were 15 percent higher, could you absorb it? What about 20 percent? What’s your back-up plan if you can no longer afford these suppliers? How would your profit margins and working capital be impacted?

Then, think about your family’s cost of living. If tides turned and those costs increased 15 to 20 percent, could you make that work? Where would you cut costs if needed?

Finally, enhance your awareness of currencies. Select several currencies of interest – those that affect your investments, ability to travel or purchasing power. Track them to see how their movements could affect your financial wellbeing over time.

We’re here to help.

It’s reassuring to work with a foreign exchange expert. We can help you devise a strategy to navigate global turbulence and provide a framework for understanding your foreign currency exposure. 

Don’t procrastinate. Uncertainty is part of life, but preparation creates resilience.