- On 21 September the Federal Reserve raised rates by 0.75 points for the third consecutive time and signalled more rises.
- US rates rose above 3%, and the dollar kept strengthening against the euro.
- With a dear dollar, what is paid in that currency weighs more: it is wise to identify which costs are in dollars and consider hedging the exchange rate.
On 21 September 2022 the Federal Reserve raised interest rates by 0.75 points for the third consecutive time and signalled more rises. With that move, US rates rose above 3%. The dollar kept strengthening against the euro, in a context in which the differences between the monetary policies on the two sides of the Atlantic increasingly influenced the relative value of the two currencies.
A sequence of three successive rises of this size is unusual and reflected the central bank’s determination to curb prices. For the rest of the world, it has an indirect but powerful effect: a stronger dollar makes imports priced in that currency dearer and complicates the position of countries and companies indebted in dollars. Understanding this helps to interpret many of the movements seen in markets. Emerging markets and companies indebted in dollars are, in general, the most sensitive to this kind of episode, because their debt becomes dearer at the same time as their currency weakens.
A pace that does not ease
With the third successive rise of 0.75 points, US rates rose above 3%. The central bank was not only raising rates but warning that it would keep doing so, and that influences the expectations of companies, families and investors. Each additional point in rates alters the relative appeal of assets and currencies.
Expectations about future rates are as important as the current level, because markets price in what they expect. If rates are expected to keep rising, the cost of long-term debt and the value of many assets adjust in advance. That is why, even though the next decision has not yet been taken, its effects are already seen in today’s prices. Anyone operating internationally would do well to distinguish between a one-off move in the exchange rate and the trend, and not draw conclusions from a single day.
Why the dollar strengthens
When a central bank raises rates faster than others, its currency tends to strengthen, because investing in it becomes more attractive. A strong dollar against the euro means that anyone paying in dollars needs more euros to do so.
The exchange rate between two currencies responds to many factors, but the difference in interest rates is one of the most influential. If money earns more in one economy, capital tends to flow towards it and demand its currency. While that difference persists or widens, the dollar may stay strong, although nobody can say how long that behaviour will last. A strong exchange rate is an opportunity for some and a problem for others, and the difference usually lies in the make-up of income and expenses.
What weighs more in the accounts
With a dear dollar, everything paid in that currency (energy, technology, raw materials) weighed more in European companies’ accounts. It is worth identifying what part of costs is denominated in dollars, studying whether prices can be fixed or the exchange rate hedged, and assessing the effect on margins over the coming months.
A practical analysis is to list suppliers and contracts with payments in dollars, estimate the annual volume and calculate the effect of a change in the exchange rate. With that figure, the available hedges, the cost of each and whether they are worthwhile against the risk can be assessed. It is also possible to review whether some selling prices should include a clause adjusting for currency changes. And review with suppliers the possibility of paying in euros or sharing the exchange-rate risk, something that is sometimes negotiated without difficulty.
A currency change can erode a margin without anyone having touched the price.
This article is general information. It is not legal, tax or investment advice, and it does not take anyone’s particular circumstances into account.
