A very important item for cross-border investors to understand in their investing lives is currency; moreover, it is an area where a full understanding of the risks and tools to mitigate those risks can make a substantial impact on a family’s financial wellbeing. However, in our opinion, the gradually strengthening dollar over the last 8 years has left many Americans abroad complacent about this risk.
While the shift will not happen overnight, the Fed’s recent lowering of interest rates is an important reminder of factors affecting currency rates and how that might lead to a longer-term secular weakening of the dollar.
Like all markets, exchange rates are shaped by supply and demand and predictions about supply and demand. In the case of exchange rates, when we speak of the dollar being strong it is because it is in demand. A big cause of global demand has been the large spread between U.S. interest rates and those of other global economies. In Europe, for instance, deposits often receive zero or even negative yields. This leads to greater demand for U.S. dollar-denominated yield, particularly for banks and other businesses with cross-border cash flows as they will hold money in dollars longer before moving it to another currency. However, lower U.S. interest rates could lower demand for the U.S. dollar as there is less benefit to keeping interest-bearing deposits in the U.S. dollar.
In these cases, moving money to, or keeping money in, dollars makes sense for these large companies particularly if one is storing cash in safe investments for the short-term. However, this is a case where strategies employed by large businesses are not necessarily the best for individuals.
In our whitepaper on portfolio management for cross-border investors, we discuss how to build a long-term investment portfolio to manage currency rates, but many investors can get themselves in trouble when dealing with short-term cash reserves. Currently, many American expats are frustrated by the low interest rates they face as they save towards shorter-term goals in their local currency and may be tempted to store interest-bearing deposits in the United States dollar. While keeping cash in dollars (particularly if the firm hedges the risk) for a few extra days can allow a global firm to earn a bit of extra interest, the risks and costs for individual investors can be significant.
By way of example, let’s examine the situation for a client holding 100,000 in Euros for a house project in one year in a completely stable currency exchange rate environment (that is the currency exchange rate never fluctuates). If they invest that at current interest rates in Europe (0%) one year from today they will still have 100,000 Euros. Instead, should they convert that same 100,000 euros to dollars at current exchange rates (1 EUR= 1.11 USD), they would start with 111,000 USD. They could then park it in a 12-month CD at current interest rates (approximately 2.35%), they would end the year with a total of 113,608.5 USD at the end of the year-- earning approximately 2,608.50 USD in interest. If at that point, they then choose to return the money to Euros in 12 months at the same exchange rate as the beginning of the year (1 USD= .9 EUR) over the year, they would ultimately have 102,247.65 Euros (not including any fees) for their house projects. In a world where there is no change in exchange rates, moving money to the U.S. for its higher interest rate would make perfect sense.
However, the world doesn’t exist in a vacuum of stable exchange rates. And while the U.S. dollar has trended up over the last eight years, it has not done so in a straight line and 2017 is an example of the significant currency rate risk that an individual investor can face. On January 1, 2017, an investor could have moved 100,000 Euros and received 105,600 dollars at the prevailing exchange rates (1 EUR: 1.056 USD). Again, if they had moved that money into a 12-month CD earning .4% (the approximate 12-month CD interest rate in 2017) they would have ended the year with 106,022 USD. However, the dollar declined during the course of the year and the investor moving money back to Euros on January 1, 2018, would have received back 88,351 Euros at the January 1, 2018 exchange rates (1 USD =.83EUR). Their “safe” investment would have lost roughly 11,500 Euros.
In a sense, currency risk functions very differently from portfolio risk which lessens over time. In fact, as the Fed’s announcement reminds us, thinking through the factors affecting currency can help us better understand the risks cross-border investors face and the benefits of fully understanding one’s own financial picture in order to help mitigate these risks.
In forthcoming blogs and a whitepaper, we’ll discuss additional tools investors can use to manage these various risks, so watch this space.
Disclosure: The above currency examples are made for illustrative purposes only and are not intended to encourage any investor behavior.