Data analysis HSBC Research has produced for the past six years shows that the sterling-US dollar (£/$) exchange rate has a tendency to rise in December.
However, last year, the £/$ fell in December for the first time in seven years but the weight of money through the corporate sector still exerted an influence on the £/$ exchange rate and there was a positive move in the first week of this year.
The £/$ fell 0.8% during December but rose a whopping 3.2% in the first week of January.
The analysis here concentrates on how £/$ trades over the month of December. It has been found that there is a significant tendency for the £/$ to rise in December.
Since 1991 the average rise in sterling is of around 1.6% in December. In fact, the £/$ has risen 12 out of the past 14 years. Some may argue this anomaly should be arbitraged away.
Indeed, this may be happening, thereby seeing this effect occur in January rather than December. As this phenomenon is becoming better known, there was a small fall last year and only a small rise the year before.
Monitoring daily £/$ prices from 1989 to the present, it is clear that in December there are the largest average daily returns. The average daily return is around seven basis-points for December, which outstrips any other month by a large margin.
If the £/$ were to follow the same path of the past six years, the forecast is that it will rise by around 2.4% this month.
Is this a generic sterling move? Not at all. The sterling move is due to the repatriation of UK-based overseas corporate US dollar earnings from the US, and this would suggest the move should be in £/$ and not a generic sterling move.
Around half the FTSE350 (largest 350 UK listed companies) have a December year-end date. Now that there is the quantitative evidence for the phenomenon of the £/$'s rise, an explanation of why this might occur is needed.
First and foremost it is vital to note that around half of all FTSE350 companies have a December reporting season. This means that these companies need to repatriate profits made in the US by December and hedge their balance sheets.
No prudent company can carry currency risk on behalf of its shareholders once the results are established. Thus, the repatriation must take place prior to the year end, and that of course means that corporate flows can have a more dominant effect on the spot rate in December.
It is also important to keep the flows of FTSE350 earnings in context. Roughly half of all FTSE350 earnings are derived from overseas operations. From that, roughly half are derived from the US, implying the US is responsible for a quarter of all FTSE350 earnings.
Taking this a step further, and keeping in mind that half UK companies have a December year end, one can then estimate that over 12.5% of FTSE350 earnings come from the US and have a December year end.
In amounts, it is estimated that the FTSE All-Share earned about GBP £134 billion in post-tax profits this year, a quarter of which (£33 billion) were derived from the US. With half of the UK companies having a December year-end that means that pre-tax profits from the US with a December year-end was around £17 billion this year.
Of course, this flow streams through as the year progresses but most importantly the peak of the flow takes place close to year end.
Repatriated profits are expected to rise to a record this year. If this rise in post-tax profits coincides with a larger than usual fall in currency flows, then the £/$ will have plenty of upside.
However, the repatriation of profits is not the only reason corporates act in December, as they also need to carry out balance sheet re-hedging of overseas assets.
It is not inconceivable that the market is now geared for this effect and pre-empts the rise with a move up in the £/$ in late November. The flow is not just related to profit repatriation.
In terms of balance sheet management, the US still accounts for the largest region of existing overseas investment by UK companies. To preserve the value of these US dollar investments they need to protect themselves against a possible sterling appreciation versus the US dollar, especially if these assets have fallen dramatically in value.
Secondly, general interest in foreign exchange tends to fall in December. Using data from the Chicago Mercantile Exchange (CME), the open positions in the £/$ were looked at since 1995.
The data clearly shows a fall in the open interest in December. On average the open interest is roughly 23% lower in sterling during December than November. Thus, the seasonal flow impact takes place at a time of reduced liquidity and hence the price action is greater than at other times of the year.
Although the £/$'s December effect may be changing and therefore the timing of this effect may be pushed into late November or early January, there may continue to be many companies which choose or are forced to wait until late December to act.
This suggests that this anomaly will persist. Hence, the persistence of the December £/$ exchange rate effect.
This report was compiled by Peter Calleya, manager, Corporate Strategy and Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.