Some of the largest U.S. asset holders have little protection against a weakening dollar, leaving the currency vulnerable to sharper declines if market sentiment shifts abruptly.
As of June 30, investors in markets including Japan, Canada, and Taiwan had hedged only 41% of their foreign exchange risk exposure—the lowest level since at least 2015.
By reducing their hedging, investors are effectively reverting to a strategy that has worked well over the past decade: when market volatility rises, the dollar typically strengthens or at least holds steady, cushioning losses when investors convert U.S. stocks and bonds back into their home currencies. Moreover, given the high cost of hedging, there is little incentive for investors to pay for protection.
The current risk lies in the fact that the two pillars supporting this strategy—high hedging costs and the dollar’s safe-haven status—are now being challenged simultaneously.
The dollar has declined by about 2% this quarter against most G10 currencies as investors renewed depreciation bets, anticipating that U.S. policy would weaken the currency. Measures taken by U.S. Treasury Secretary Scott Biden to support the yen and contain rising U.S. Treasury yields have intensified these concerns. Meanwhile, with President Trump pushing for lower borrowing costs, investors are questioning whether Federal Reserve Chair Kevin Warsh will raise interest rates to combat inflation.
Hedging involves using derivatives to sell dollars and buy domestic currencies, protecting investors from exchange rate fluctuations. Given the large share of U.S. assets in global portfolios, increased hedging effectively means selling more dollars.
“Given the scale of foreign holdings of U.S. assets, even small changes in position can have an impact,” said Laura Cooper, head of macro credit at Nuveen, which manages $1.4 trillion in assets. “Foreign investors hold substantial amounts of U.S. assets, so even a slight shift in hedging ratios could trigger significant foreign exchange flows.”
With the direction of U.S. interest rates still unclear, Warsh’s comments have left investors uncertain about the Fed’s commitment to controlling inflation. His pledge on Friday at the Jackson Hole meeting to tackle price pressures boosted expectations for rate hikes. Yet investors are also weighing pressure from the Trump administration to keep borrowing costs low, especially ahead of the midterm elections.
“If markets continue to price in Fed tightening and interest rate differentials narrow, investors may begin rebuilding their hedge positions,” said Nathan Tufft, chief investment officer of the multi-asset solutions team at Manulife Investment Management. “This will continue to put downward pressure on the dollar.”
Stuart Simmons, head of multi-asset solutions at QIC Ltd., one of Australia’s largest state-owned asset managers, said relying on a 70% dollar-linked foreign exchange basket as a defensive tool may no longer be effective.
“In today’s era of heightened geopolitical uncertainty, do you really feel confident that the dollar will remain the primary safe haven?” Simmons asked. “We recommend exploring other options to ensure your foreign exchange portfolio is more diversified.”