Should you use currency hedging to beat inflation and stay liquid?

Published On: May 2, 2022Categories: Latest News5.7 min read

It’s not a secret that the real value of cash is eroded over time if interest rates are lower than inflation. In recent years, that reality has been one of the strongest arguments against holding cash. However, the argument has strengthened considerably over the past year.

The best cash interest rates currently available are around 1.5% for easy access savings accounts and up to around 3% for a limited period on fixed term savings accounts. That’s only slightly better than the rates available over the previous couple of years.

The difference is, inflation rates have run at less than 3% for most the last decade and at lower than 2% for extend periods since 2014. So while interest rates on offer have been lower than that meaning the real value of cash holdings was still being eroded, the situation wasn’t drastic.

For many, the security and convenience of holding at least some wealth in liquid cash has been worth the trade off of it losing a 1% or so in purchasing power annually.

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Source: TradingEconomics

But holding cash is suddenly a harder position to justify. From barely above zero in 2020 and early 2021, the UK’s inflation rate has rocketed to over 7%. And while it may have already peaked and is expected to ease from those heights as the year goes on, inflation is expected to remain elevated at much higher levels than recently over at least the next couple of years.

Realistically, holding cash over the next two to three years is likely to mean it losing somewhere in the region of 5% in real value annually once interest is accounted for. It could be a little less or it could be more. But cash holdings will almost certainly lose significant purchasing power.

Stock markets are also not doing great but they have also historically always recovered from downturns. So as long as investors don’t have to cash in investments, they should be able to ride the downturn out.

But real cash value doesn’t recover from inflation unless deflation occurs, which no economy wants and is unlikely to happen. Value lost to inflation is, realistically, gone for good.

But we’re also regularly advised, if at all possible, to hold between 3 and 6 months of monthly expenses in cash as a rainy day fund. Doing so provides valuable liquidity and prevents the need to cash in investments, potentially at an inopportune moment for markets, if unexpected expenses arise or regular monthly income dries up for a period.

Some people also simply prefer to hold more cash for personal reasons, even in the knowledge doing so is financially unattractive.

Is there anything you can do to still hold larger sums of cash but offset or minimise the impact of inflation?

Can you take advantage of currency markets to offset the impact of inflation on real cash value?

One way to try to offset the hit to the real value of cash is to hold it in different currencies. Most people associate currency, or forex, markets with risky short-term trading using leveraged financial instruments like CFDs. Traders buy and sell different fiat currencies like pound sterling, euro, yen, Swiss franc and the U.S., Australian and Canadian dollars with the aim of profiting from their market movements against each other.

Fiat currencies are free floating and rise and fall in value against each other based on the usual market forces of supply and demand. When central banks embark on quantitative easing that increases the supply of a currency and, if that supply is increasing faster than that of other major currencies, usually results in it losing value against peers.

When central banks raise base interest rates it usually has the opposite effect. It becomes more attractive to hold that currency, increasing demand, which pushes up relative value.

Multiple factors affect the relative value of the major currencies and they can significantly gain and lose value against each other over time. By last week, for example, Sterling had lost 4.2% against the dollar in April, its biggest monthly decline since October 2016.

Anyone who had sold pounds for dollars at the end of March would have made, on paper, 4.2%. Since its most recent high in 2017, the pound has lost almost 40% against the U.S. dollar. Holding dollars instead of pounds would have more than offset inflation over those 5 years, leaving a healthy profit if the cash were converted back to pounds today.

With the Fed signalling it will raise interest rates more aggressively than the Bank of England this year, combined with the fact the U.S. dollar typically gains against its peers during periods of economic turmoil and geopolitical risk, the dollar could well be set to strengthen further against the pound. If that scenario were to play out, holding cash in dollars rather than pounds, could potentially offset losses to inflation.

The Japanese yen, historically seen as a safe haven currency, has also fallen to 20-year lows against the dollar. The yen has fallen 13% against the U.S. dollar since the war in Ukraine began, and more than 20% over the past 12 months.

The yen’s drop in relative value is attributed to the difference between the yields on Japanese government bonds and those of other countries. The Bank of Japan has limited the return on its 10-year government bond to 0.25%. The US Treasury’s equivalent yield is 2.82%.

However, many currency market specialists believe that the extent of the yen’s drop in value against the USD will be temporary. There may be some further headwinds resulting from Japan’s reliance on energy imports but over the medium-term, most analysts expect the yen to firm up against the USD, even if it doesn’t return to historical averages.

The Swiss Franc is another currency often considered a safe haven. It has strengthened 6.5% against the pound over the past year so anyone who had bought it for pounds then would have, on paper, largely offset the UK’s rate of inflation over the same period.

There’s risk involved but currency hedging can help cash holdings reduce the impact of inflation

Buying and selling currencies with a mid-term horizon is a lot less risky than day trading but still involves a level of risk. While all the signs point to the U.S. dollar gaining in value against the pound over the next year or so, there are no guarantees. Holding cash, or part of cash holdings, in U.S. dollars could well help reduce inflation-led losses to real value but involves taking on a level of risk.

There’s a strong argument that risk is low enough that it is worth taking against the near guarantee of significant real value losses to cash held in pounds. But it still has to be appreciated by anyone considering currency hedging.

A lower risk option would be to split cash holdings between a few different currencies such as the U.S. dollar, yen and Swiss franc, while retaining a modest cash buffer in pound sterling. That could well be less effective as an inflation hedge than holding only U.S. dollars and some pounds. But it also reduces the risk of an unexpected run on the dollar.

But for anyone who does hold significant sums in cash, as a rainy day fund or more because greater liquidity is valued for personal reasons, currency hedging is worth considering as a tool to ease inflation-based value erosion.

About the Author: Jonathan Adams

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