By reducing USD exposure while retaining exposure to U.S. assets, investors can maintain their investment in the U.S. markets while managing currency risk.
In Brief
- The decline in U.S. equities, bonds, and the USD has led investors to reassess the USD's role as a diversifier to U.S. assets and the need for currency hedging.
- The USD remains expensive. An economic slowdown in the U.S. and policy directions could pressure the USD to a gradual depreciation.
- Hedging remains appealing to “policy proof” portfolios, and partial hedges with an active approach can mitigate the tail risk of sharp USD declines.
The recent “triple threat” in U.S. markets, in which equities, bonds and the U.S. dollar (USD) all declined in synchrony, has prompted investors to reassess the USD’s role as a diversifier to U.S. financial assets and reconsider the necessity of hedging their portfolio’s currency exposure against the USD. While the USD’s role can remain dominant in the long-term, given its entrenched structural significance in global finance, there could still be gaps of cyclical depreciation for the USD. As such, this note revisits recent trends in the USD and hedging strategies, discusses the medium-term outlook for the USD, and explores implications for currency hedging among Asian investors.
A slow build-up
The USD’s status as a global funding currency, coupled with the sheer size and depth of U.S. capital markets, has nurtured a century-long vicious cycle of attracting more investors and issuers to the USD market. This, alongside multiple years of outperformance in U.S. capital markets, has led U.S. assets to occupy a growing share in foreign investors’ portfolio investments.
Typically, as foreign investments in portfolios increase, currency hedging also tends to rise as a means to mitigate overall risks in local currency terms. The extent of hedging depends on investor profile and investment objectives, particularly if there are any obligations in local currency terms. However, the USD’s historical reputation as a safe haven has resulted in lower volatility in local currency terms for foreign investors with unhedged U.S. assets exposure. Consequently, hedging ratios on U.S. assets tend to be lower than those for assets denominated in other currencies.
A confluence of the Federal Reserve’s (Fed) rate hiking cycle from 2022, which led to higher short-term USD interest rates and thereby making hedging against the USD more expensive, and broad optimism on a stronger USD has contributed to further reductions in hedging ratios in recent years. With the Fed’s easing cycle stalled on risk of reflation, hedging costs against the USD for Asian currencies became even more expensive since the start of this year (Exhibit 1). As such, the decline in hedging ratios was more pronounced amongst Asian investors, exacerbating losses when the USD saw a sharp depreciation earlier this year.
A slow decline
With the USD experiencing five consecutive months of decline, and the DXY index and the Asia TWI1 marking a year-to-date decline of 9.0% and 4.1%, respectively, this recent weakness of the USD has reminded investors to revisit currency exposures in portfolios. However, given the increased hedging costs against the USD for most Asian currencies since the start of the year, the conclusion on this cost-benefit trade-off is less apparent.
From a valuation perspective, despite having retreated from extremely stretched levels, the USD still sits on the more expensive side of its historical range. In real effective exchange rate (REER) terms, the USD currently trades at 7.3% above its long-term average, representing a premium of 0.22 standard deviation.
Indeed, our base case remains that, although U.S. economic growth may narrowly avoid a recession, a near-term slowdown is anticipated, exerting downward pressure on the USD. Policy directions from the Trump administration on current account and fiscal deficits also necessitate a weaker USD to restore balance. Barring a re-escalation in global trade tensions or threats to the central bank independence, sharp declines on the USD appear unlikely from current levels, and we expect a gradual depreciation in the USD in the near-term.
In this scenario, hedging strategies may seem less attractive as a short-term approach, especially given the relatively higher costs associated with the gradual USD decline.
Investment implications
While currency hedging may incur higher costs than the benefits it provides in the short term, strategic hedging becomes increasingly appealing over a longer horizon, especially as a means to safeguard against potential policy shocks and sharp USD depreciations. If U.S. policies result in a destabilizing state for the economy, particularly concerning the case of central bank independence, confidence in its currency will diminish, eroding the USD’s traditional safe haven status and amplifying volatility for portfolios with unhedged exposure to U.S. assets. An increase in hedging by institutions would also mechanically contribute to further USD depreciation. As such, U.S. assets with a partial hedge against USD exposure could balance between the base case of a gradual USD decline and the tail risk of sharp USD falls, and an active approach to dynamically manage the hedging ratio will be crucial to navigate the evolving landscape.
Additionally, the recent strength of the USD has resulted in U.S. assets providing strong returns through both the underlying asset performance and the currency return when converted back to domestic currency terms. We remain constructive on U.S. equities, but the potential currency tailwind may have faded. By reducing USD exposure while retaining exposure to U.S. assets, investors can maintain their investment in the U.S. markets while managing currency risk.
Conversely, for APAC investors with USD-denominated portfolios or liabilities, the higher hedging costs against the USD imply a higher hedging premium against other currencies. This presents an opportunity for investors to take hedged exposure to global government bonds, as the hedging premium enhances local government bond yields, offering a yield advantage to traditional U.S. treasuries.
While the yields on U.S. treasuries may drift higher on fiscal concerns, increased spending in Europe and monetary tightening in Japan also could push yields upwards. Nonetheless, incorporating hedged global government bonds into portfolios can enhance diversification benefits while boosting yields on the total bond portfolio.