As of today, the U.S. government has been shut down for six days. Federal employees deemed non-essential aren’t showing up at the office, their incomes have been interrupted, and many services have ground to a halt. Less consequentially, scores of tourists won’t be watching Old Faithful erupt every ninety minutes (which leads one to ask – does a geyser still erupt if tourists aren’t around to watch?), and children won’t be pointing in wonder at the crack in the Liberty Bell. On the bright side, the IRS has ceased all audit activity, the Department of Agriculture continues its vitally important beef inspections, and even though the panda webcams have been switched off, all of the National Zoo’s animals will continue to get their rations.
For those actively engaged in the financial markets, the government shutdown is also notable for its halting the release of key economic data. Three days ago, for the first Friday of the month in many years – the last government shutdown was in 1996 – the Bureau of Labor Statistics did not publish the non-farm payroll and unemployment numbers. Most economists and investors regard these numbers as bellwethers for economic expansion or recession, so their absence after metronomic regularity did much to disrupt the natural financial rhythms of the markets.
Over the last two years, the unemployment rate has been on a steadily improving course, presaging better economic conditions for the country. But given the lack of a published rate today, we have to ask the question – how important is it really, or more precisely, how much information does it actually contain about the economy’s present and future vitality? After all, it:
Treats part-time and full-time work equivalently: According to the BLS, since January of 2009 part-time employment has increased by 1.9 million, while full-time employment has increased by only 270 thousand, one-eighth of the total. Each of these created jobs will reduce the unemployment rate, but will not yield equivalent income and benefits to the job-holders.
Improves when people give up looking for work: Since the beginning of 2009, the unemployment rate has improved from 7.8% to 7.3%, but the ratio of workforce to population has fallen from 60.6% to 58.6%. Leaving the workforce helps the unemployment rate, but not household income or GDP.
Fails to capture “quality” of jobs produced: As an example, over the past five years, manufacturing jobs in America have fallen by 1.4 million, while food service and drinking establishment jobs have risen by 750 thousand. Historically, manufacturing jobs have tended to compensate higher and be accompanied by better benefits.
Disregards duration spent unemployed: Five years ago, the mean duration of unemployment was 18 weeks; today it has more than doubled to 37 weeks. Longer time spent unemployed saps household savings and expands credit purchases significantly.
Naturally, government statistics aren’t the only numbers that need to be subjected to thoughtful scrutiny. When companies think about how to quantify the true costs of their currency risk management programs, it’s tempting to focus only on the visible cost drivers, such as market pricing for the hedges themselves, credit charges or profit margins applied by dealer banks, and any gain or loss that stems from settling the hedges. These quantifiable costs are vitally important, but there are also equally important but more subtle issues to consider, including:
Optimized trading: Executing more transactions than necessary carries a real price tag, particularly when each trade has a minimum level of profitability required by the dealer. Additionally, if hedges are executed in opposite directions, this will mean crossing the bid-offer spread and executing on the less favorable side of the market. By netting positions internally and flattening exposures across entities where possible, companies can reduce both the total number of trades and the total notional hedged, saving on costs.
Optimized risk reduction: A company may be exposed to dozens of currencies, but the incremental risk reduction of each new hedged currency will generally not be equal. Because of the cross-correlation of currency movements, “intuitive” approaches like hedging the largest notional exposure will not always be the best hedge; in certain instances, it may actually increase risk. Weighed against the detriments of hedging too many currencies, or hedging the wrong currencies, using the additional analytical and technology tools needed to determine optimal hedging order and notional amounts may prove far more cost effective.
Optimized structure: In most cases, simpler trades will allow for greater pricing visibility and more efficient pricing. Complex structures involving compound products, embedded optionality, or non-standard terms will often drive pricing up and transparency down. The flexibility afforded by the over-the-counter market is very useful in tailoring hedges to match risk profiles when needed, but generally a simple trade rather than a complex structured one will be the most efficient means to mitigate risk.
Optimized program maintenance: To maintain an effective FX hedging program, it takes specialized expertise in transaction execution, hedge accounting, and regulatory compliance. It can also require using a technology solution to aggregate exposures accurately and recommend appropriate hedges. Investing in outsourcing the hedge accounting or exposure management function is a tangible cost, but it can be a powerful aid in minimizing P&L volatility or reducing unneeded hedge transactions.
An optimized currency hedging program requires holistic evaluation of direct and indirect costs associated with program structure and maintenance, weighed against the risk mitigation benefits afforded and the opportunity costs of not hedging. And here’s hoping the National Zoo’s panda cams, and the Old Faithful geyser, get turned back on by then! If you have any questions, give us a call at 610.925.3120 or email us.