Global investors' dollar hedging ratio hit a ten-year low, putting downward pressure on the dollar.

Global institutional investors hold massive amounts of US assets, yet are virtually unprotected against the depreciation of the dollar, a situation that is creating systemic risks for the dollar.

According to Bloomberg's calculations based on data from six markets, as of June 30 this year, the hedging ratio of foreign exchange exposure for pension and insurance institutions in major markets such as Japan and Canada was only 41%, the lowest level since 2015.

This means that once market sentiment reverses, large-scale hedging replenishment will directly translate into selling pressure on the US dollar. Bloomberg estimates that the total foreign currency holdings in the aforementioned six markets amount to approximately $4.6 trillion, and every 5 percentage point increase in the hedging ratio will trigger approximately $230 billion in trading volume.

Currently, the two core logics supporting the low-hedging strategy— high hedging costs and the safe-haven status of the US dollar— are both being shaken. The US dollar has weakened against all G10 currencies this quarter, with a cumulative decline of approximately 2.6%.

At the same time, investors’ confused expectations about the Fed’s interest rate path, the US Treasury’s support for the long-term bond market, and the decline in the dollar’s safe-haven appeal have all contributed to increased market bets on “dollar depreciation trades”.

Low hedging ratios accumulate risk

Over the past decade, institutional investors have generally chosen to hold a large amount of unhedged dollar assets. The logic is that the dollar tends to appreciate during market turmoil, naturally acting as a risk buffer; and hedging costs are high, making active protection unprofitable.

However, the effectiveness of this strategy is being questioned. Laura Cooper, head of macro credit at Nuveen, which manages $1.4 trillion in assets, stated:

Given the size of foreign investors' holdings of U.S. assets, a significant change in the hedging ratio is not necessary to have a substantial impact. Even a small shift in the hedging ratio can drive considerable foreign exchange flows.

It is worth noting that Bloomberg's calculations do not yet cover major markets such as the UK and the Eurozone, but the countries covered already represent a significant proportion of US asset holdings.

Japan is the world's largest foreign holder of U.S. Treasury bonds, accounting for about 10% of total foreign holdings, while Canada is also among the top ten.

Decreasing hedging costs increase the incentive to rebuild hedging.

The key factors that drove the hedge ratio down from over 50% four years ago are quietly reversing.

The narrowing interest rate differential is one of the most direct variables. The cost for yen-denominated investors to hedge against a three-month dollar hedging strategy has fallen from a peak of 6% in October 2023 to the current 2.75%, a four-year low; the hedging cost for eurozone investors has also fallen to 1.32%, a two-year low.

Nathan Thooft, Chief Investment Officer of the Multi-Asset Solutions Team at Manulife Investment Management, stated:

If the market continues to digest the expectation that the Federal Reserve will not raise interest rates and interest rate spreads narrow further, investors may begin to rebuild their hedging. This will create sustained selling pressure on the US dollar.

Meanwhile, inflationary pressures from the war in Iran and soaring energy prices are pushing global central banks toward a tighter stance, further narrowing the interest rate gap with the United States and diminishing the relative attractiveness of holding unhedged dollar assets.

The safe-haven status of the US dollar is being questioned.

In addition to cost factors, the structural hedging logic of the US dollar is also facing deeper challenges.

The U.S. Treasury’s large-scale long-term debt purchase program to suppress borrowing costs, along with coordinated U.S.-Japan currency interventions, have raised doubts in the market about whether U.S. authorities are willing to sacrifice the dollar to maintain financial stability.

Noureldeen Al Hammoury, Chief Market Strategist at Equiti Group, pointed out:

If investors’ confidence in the dollar’s reliable appreciation during periods of market stress declines, they will be less tolerant of large unhedged currency exposures.

He also emphasized that investors do not need to sell off US assets themselves. They can increase currency hedging by selling dollars forward while holding stocks or Treasury bonds. Noureldeen AlHammoury added:

This distinction is important because it means that even if the dollar is under pressure, demand for US assets may remain relatively robust.

Stuart Simmons, head of multi-asset solutions at QIC Ltd., one of Australia's largest government-backed asset managers, said that relying on a foreign currency basket with 70% exposure concentrated in the US dollar as a defensive tool may no longer be effective. He said:

In an era of heightened geopolitical uncertainty, are you truly confident that the US dollar will continue to be the primary means of defense? We suggest examining some alternatives to ensure a more adequate diversification of your foreign currency basket.

Japan may become a key trigger point.

Japan’s risk exposure is particularly prominent in the potential wave of hedged restructuring.

According to Deutsche Bank estimates, Japanese investors hedged only 41% of their new foreign bond purchases in the first half of this year, a significant drop from 62% in 2024.

Shoki Omori, chief fixed income strategist at Deutsche Bank in Japan, pointed out that the last time hedging ratios were this low was in 2013, when the US dollar embarked on a decade-long bull market. "Today's macroeconomic environment looks more like a mirror image of that history."

Omori identified three catalysts that could trigger hedging reconstruction:

The Bank of Japan further raised interest rates, narrowing the interest rate gap.The sharp drop in the US dollar exacerbated the losses, forcing the risk committee to request additional protection.And the new solvency regulatory framework imposes restrictions on insurance companies' tolerance for exchange rate fluctuations.

Wells Fargo strategist Erik Nelson cautioned that the impact of hedging on the dollar should not be over-interpreted, and that monetary policy remains the more dominant long-term driver.

However, he also pointed out that given European funds' large unhedgeed positions in US stocks, as the cost of shorting the dollar declines, investors have more room to increase hedging, and the euro may be a major beneficiary. Erik Nelson emphasized:

Any sign that the US dollar underperforms amid risk aversion could trigger a rapid shift in foreign exchange hedging behavior, thereby accelerating the dollar's decline.

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