USD Regime Change: Assessing FX Hedging Flows

In mid-April, changes in the US dollar’s relationship with US yields and equities raised questions on whether the currency was undergoing a regime change and was set for a period of structural decline. This past month has tempered some of these discussions, as elevated geopolitical risk in the Middle East prompted a return of the safe-haven bid for the USD, even if briefly. The USD rallied as global equities fell – a sign of the USD’s haven status. The currency’s relationship with US yields also appears to be normalising; recent USD declines have more generally been associated with lower US yields, for example. The frequency of recent “Sell America” days – when the USD, US equities and US bonds all declined together – has been gradually declining.

The reversion of the US dollar-US equity correlation may have some implications for FX hedging of US asset holdings by international investors. For many years, holding US equities with no FX hedging helped to dampen volatility for institutional investors. When US equities fell in value, the USD usually strengthened, limiting the downside to these portfolios in local currency terms. The debate has been whether the concurrent decline in the US dollar and US stocks would cause international investors to raise their FX hedging ratios (selling US dollars) to curb portfolio volatility and enhance performance. There has already been some evidence of a rise in FX-hedging of US assets (from Danish pension funds, for example), but the recent reversal in correlations could challenge the idea that a significant shift in hedging behavior is necessary.

Another factor driving FX hedging decisions may be the impact on underlying portfolio returns and volatility. For the low yielders, even after accounting for the cost of FX hedging, the volatility-adjusted returns of a fully FX-hedged investment have been notably higher than those for unhedged investment. This could suggest a greater incentive to increase FX hedging ratios on US equity investments. However, FX-hedged returns have significantly exceeded non-FX hedged returns in the past, without necessarily triggering a huge shift in FX hedging behavior, so a significant change in hedging ratios may only come about if there is a more protracted period of outperformance of FX-hedged portfolios.

Irrespective of the FX hedging and correlation themes, a consistent pattern of gradual US asset sales has emerged in recent months. The latest data show persistent outflows from US-focused equity ETFs listed outside the US, while the Treasury’s monthly portfolio flow statistics show outflows from the US in April.

Looking at the timing of US dollar movements this year, Asia appears to have been the most prominent seller against a range of G10 currencies. This supports the view that there is some asset reallocation among large investors from Asian surplus economies, but not necessarily significant direct repatriation into Europe or outflows from US-domiciled investors.

If these latter trends start changing, it might become more of a powerful US dollar driver. However, for that to happen, the US macro outlook might need to worsen more substantially, or the euro area may need to show more signs of outright positivity, as opposed to just benefiting from a decline in sentiment regarding the US.

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