The dollar sank to the lowest level since May on Thursday, September 3 after Federal Reserve Governor Christopher Waller noted progress on inflation and as the yen surged against its major counterparts.
The Bloomberg Dollar Spot Index fell 0.6% on Thursday, dropping against all of its Group-of-10 peers. The yen led gains, climbing 2.1% versus the greenback, as traders boosted bets on Bank of Japan interest-rate hikes and remained on alert for signs authorities were potentially stepping in to bolster the Japanese currency.
The dollar is down about 2.6% this quarter and has weakened against all G10 peers as investors revive the debasement trade, the view that U.S. policies will erode the currency’s value. Treasury Secretary Scott Bessent’s moves to support the yen and contain rising U.S. yields have fueled those concerns, as have doubts over whether Federal Reserve Chair Kevin Warsh will raise rates to curb inflation amid Trump’s push for lower borrowing costs.
The fact that the dollar moved so strongly lower on such a relatively minor catalsyt–one Fed governor saying the inflation picture might be improving tells us a lot about the underlying structure of the currency market right now.
Yes, the financial markets don’t have a lot of faith tyat Treasury Secretary Scott Bessent and Federal Reserve chair Kevin Warsh won’t use inflation and a weak dollar to solve the $40 trillion U.S. debt problem.
But perhaps even more importantly in the short run–say the nex six months or so, the big holders of US. dollar assets have gone into the recent sell off in the dollar way underhedged. If these investors simply move back to historic levels of hedging their portfolios against a decline in the dollar, we‘re looking at the equivilent of a lot of dollar selling.
Across markets including Japan, Canada and Taiwan, pension funds and insurers–big holders ofdollar-denominated assets had hedged just 41% of their foreign-currency exposure as of June 30—-the lowest since at least 2015– according to Bloomberg calculations using data from six markets where such figures are available.
Hedging protects investors from currency swings by using derivatives to sell the dollar for their home currency. Because U.S. assets make up a large share of global portfolios, increased hedging effectively means more dollar selling.
Simply moving back to historical levels of hedging means a lot of dollar selling.
“Given the scale of foreign holdings of U.S. assets, it doesn’t take a dramatic change in positioning to matter,” Laura Cooper, the London-based head of macro credit at Nuveen, which oversees $1.4 trillion, told Bloomberg. “Foreign investors hold a sizeable stock of U.S. assets, so even small shifts in hedge ratios can drive meaningful FX flows.”
A five-percentage-point increase in hedge ratios would translate into around $230 billion of transactions, according to Bloomberg estimates based on $4.6 trillion of foreign-currency holdings across the six markets, which also include Australia, Denmark and Finland.
The Bloomberg estimate excludes major markets such as the UK and EuroZone, but the countries covered still represent a significant slice of U.S. dollar asset holdings. Japan is the world’s largest foreign holder of U.S. Treasuries, accounting for about 10% of overseas holdings, while Canada and Taiwan rank among the top 10.
“If markets continue to price out Fed hikes and interest-rate differentials narrow, investors may start rebuilding those hedges,” Nathan Thooft, chief investment officer of the multi-asset solutions team at Manulife Investment Management, saidto Bliimberg. “That creates a steady source of U.S. dollar selling pressure.”
Part of the reason that investors have wound up with such high percentages of unhedged dollar assets is that in past periods of geopolitical tutmoil, the dollar has acted as a safe haven, appreciating in price whe guns fired. That hasn’t been the case for the Iran war where investors have sold dollar assets on the fighting.
“If investors become less confident that the dollar will reliably appreciate during periods of market stress, they may see less reason to tolerate large unhedged currency exposure,” Noureldeen AlHammoury, chief market strategist at Equiti Group in Dubai, told Bloomberg.
Investors wouldn’t need to sell their U.S. assets. They can keep their stocks or Treasuries while increasing currency hedges by selling dollars forward. “That distinction is very important because it means U.S. asset demand can remain relatively strong even while the dollar comes under pressure,” he added.
