- A recent PNC webinar provided an economic outlook for businesses as they prepare for 2023, as well as an update on the performance of currencies, such as the U.S. dollar.
- PNC economists predict a potential mild recession, beginning in second quarter of 2023.
- Continued strong U.S. dollar performance in 2023 will hinge on Federal Reserve monetary policy.
- To manage FX risk, businesses should implement strong FX policies, as well as create natural hedges internally.
- FX option strategies may prove helpful during current market volatility.
Economic Forecast Points to Mild Recession
PNC Senior International Economist Abbey Omodunbi shared that the economy appears to be headed for a mild recession, beginning in the second quarter of 2023 and lasting through the end of next year. Omodunbi cited the rapid increase in the federal funds rate as the primary driver for this outlook, noting that the rate had risen from around 0% at the start of 2022 up to around 4% as the year drew to a close, with additional projected rate hikes on the horizon. Higher interest rates are likely to lead to slower growth in interest-rate-sensitive sectors, including the housing sector and business investments.
These rate hikes are the Federal Reserve’s direct response to address rapidly rising inflation, which, in Omodunbi’s view, has already passed its peak and will reach its objective of 2% by the second half of 2023. He noted that inflation also continues to be a major concern globally, with central banks in the UK, Canada, the eurozone and elsewhere following the Fed’s lead in aggressively raising interest rates.
A Strong U.S. Dollar in 2022
Tim McCarthy, managing director of PNC’s FX trading team, and FX Trader Matt Machiko noted that the U.S. dollar performed very well in 2022, reaching a 20-year high in September. Factors contributing to this growth included rising U.S. yields, thin equity sell-off and gravitation toward the dollar in light of geopolitical risk.
In Machiko’s view, whether this strong standing continues into 2023 depends on ongoing Fed policy regarding inflation. If inflation remains higher for longer, meaning the Fed is unable to lower interest rates in the near term, the dollar is likely to remain resilient. If the Fed achieves its goal of lowering inflation sooner rather than later, interest rate cuts are likely to follow, which may mean the dollar trades lower.
Other global currencies fared far poorer than the U.S. dollar in 2022, including the British pound, which hit an all-time low in September, and the euro, which in July traded below parity to its weakest level since the currency’s inception.
Managing FX Risk During Volatile Markets
Tiffany Hughes, a PNC FX specialist, highlighted that, although uncertain and volatile market conditions can create challenges, there are concrete steps businesses can take to help manage FX risk.
The first is implementing what Hughes considers the backbone of any risk management program: a clearly defined FX policy. She notes that while it may be tempting to jump into a hedge program to protect against exposure in the current market, it’s important to have clarity on what benefits such a program might offer a business. Determining this should involve input from key stakeholders within the company, such as operations teams, to ensure buy-in and mitigate potential internal friction. Companies that already have an FX policy in place should reexamine it to make sure hedging parameters still make sense for a particular business’ needs in the current market conditions.
Hughes said that businesses should also look at internal ways to reduce risk on their own, and these approaches may vary depending on the size and complexity of the company. For smaller entities, one example of a natural hedge might be to update billing processes to better align FX foreign currency denominated payables and receivables. Larger corporations might consider multilateral netting to facilitate intercompany payment settlement, as this can likely reduce FX risk and transaction costs and save time.
Once infrastructure and internal approaches to reducing risk are in place, the next step is to think about hedging, Hughes said, pointing to FX options as strategies worth considering in an uncertain market. The theory behind options is that they serve as a sort of insurance policy to help buy time for the market to recover and for potentially better rates in the future. She noted that while cost can be a deterrent to pursuing options for some companies, there are several structures available that may help meet business needs, including reduced premium, deferred premium and zero-cost option strategies.
Hughes also noted that businesses finding themselves in a favorable currency market tailwind in terms of cost of goods sold, such as those who sell products only in the U.S. but manufacture in China, might consider forward contracts, as this hedging tool can help protect against future price changes.
Ultimately, managing FX risk is a complex process, made even more so by current market conditions, and strong partnerships with financial institutions can play an important role in helping businesses develop strategic plans tailored to their specific needs.
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PNC can work with you to help manage FX risk. For more information, reach out to your PNC Relationship Manager, or click here to contact us.